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| ** U. S. SECURITIES AND EXCHANGE  COMMISSION	WASHINGTON, D.C. 20549**                                                                                                                                                                                                                                                                                                                                             |
| **FORM 10-Q**                                                                                                                                                                                                                                                                                                                                                                                                          |
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|  (X)                                                                                                                                                                                                                                                                                                                                                                                                         | QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT 	OF 1934 |  |
|                                                                                                                                                                                                                                                                                                                                                                                                                        | For the quarterly period ended **June 30, 2005** |
|                                                                                                                                                                                                                                                                                                                                                                                                                        |  |  |  |  |  | OR |  |  |  |  |  |  |
|                                                                                                                                                                                                                                                                                                                                                                                                                        |  |  |  |  |  |  |  |  |  |  |  |  |
|  (  )                                                                                                                                                                                                                                                                                                                                                                                                        | TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
|                                                                                                                                                                                                                                                                                                                                                                                                                        | For the transition period from  __________ to __________ |
|                                                                                                                                                                                                                                                                                                                                                                                                                        |  |  |  |  |  |  |  |  |  |  |  |  |
| Commission file number  0-26016                                                                                                                                                                                                                                                                                                                                                                                   |
|                                                                                                                                                                                                                                                                                                                                                                                                                        |  |  |  |  |  |  |  |  |  |  |  |  |
| **PALMETTO BANCSHARES, INC.**                                                                                                                                                                                                                                                                                                                                                                                          |
| (Exact name of registrant as  specified in its charter)                                                                                                                                                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                                                                                                                                                                        |  |  |  |  |  |  |  |  |  |  |  |  |
| **South Carolina	(State or other jurisdiction of  incorporation or organization)**                                                                                                                                                                                                                                                                                                                                     |  | **74-2235055	(IRS Employer Identification No.)** |
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|                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |  | ** ** | ** ** | ** ** | ** ** |  |
| **301 Hillcrest Drive, Laurens, South  Carolina	(Address of principal executive  offices)**                                                                                                                                                                                                                                                                                                                            |  | **29360	(Zip Code)** |
|                                                                                                                                                                                                                                                                                                                                                                                                                        |
| ** **                                                                                                                                                                                                                                                                                                                                                                                                             |  | ** ** | ** ** | ** ** | ** ** |  |  | ** ** | ** ** | ** ** | ** ** |  |
| **(864) 984-4551	(Registrant's telephone number)**                                                                                                                                                                                                                                                                                                                                                                     |  | **www.palmettobank.com	(Registrant's web site)** |
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|                                                                                                                                                                                                                                                                                                                                                                                                                        |  |  |  |  |  |  |  |  |  |  |  |  |
|      Indicate  by check mark whether the registrant (1) has filed all reports required to be  filed by Section 13 or  15(d) of the Securities Exchange Act of 1934 during the preceding 12 months  (or for such shorter period that the  registrant was required to file such reports), and (2) has been subject to  such filing requirements for the  past 90 days. Yes X   No __  |
|                                                                                                                                                                                                                                                                                                                                                                                                                        |  |  |  |  |  |  |  |  |  |  |  |  |
|      Indicate  by check mark whether the registrant is an accelerated filer (as defined in  Rule 12b-2 of the Exchange  Act).  	Yes X   No __                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                                                                                                                                                                        |  |  |  |  |  |  |  |  |  |  |  |  |
|      Indicate  the number of shares outstanding of each of the issuer's classes of common  stock, as of the latest  practicable date.                                                                                                                                                                                                                                                              |
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|                                                                                                                                                                                                                                                                                                                                                                                                                   |   |   | Class            
Outstanding at July 29, 2005            
Common stock, $5.00 par value
6,317,285 
                                                                              
 

 

PALMETTO BANCSHARES, INC. AND  SUBSIDIARY 

Table of Contents

Page No.

**PART I.   FINANCIAL INFORMATION**

3

Item 1.

Financial  Statements

3

Item 2.

Management's  Discussion and Analysis of Financial Condition and 

      Results of Operations

21

Item 3.

Quantitative  and Qualitative Disclosures about Market Risk

42

Item 4.

Controls  and Procedures

42

**PART II.   OTHER INFORMATION**

43

Item 1.

Legal  Proceedings

43

Item 2. 

Unregistered  Sales of Equity Securities and Use of Proceeds

43

Item 3.

Defaults  Upon Senior Securities

43

Item 4.

Submission  of Matters to a Vote of Security Holders

43

Item 5.

Other  Information

43

Item 6.

Exhibits	

43
**SIGNATURES**

44

 

2
PART I.  FINANCIAL INFORMATION
Item 1.  Financial Statements

PALMETTO BANCSHARES, INC. AND  SUBSIDIARY

Consolidated Balance Sheets

(dollars in thousands, except  common share data)
            
June 30,
      
December 31, 
   
2005
      
2004
   
(unaudited)
      
ASSETS
         
Cash and  cash equivalents
         
Cash and  due from banks
$
          37,635  
      
32,055 

Federal  funds sold
   
              7,260  
      
1,390 

Total  cash and cash equivalents
   
            44,895 
      
              33,445 
         
Federal  Home Loan Bank ("FHLB") stock, at cost
   
              5,339 
      
3,866  

Investment  securities available for sale, at fair market value
   
          134,121 
      
            143,733 

Mortgage  loans held for sale 
   
              4,889 
      
5,854 
         
Loans 
   
          826,802 
      
773,254 

Less  allowance for loan losses
   
             (8,051)
      
               (7,619)

Loans,  net
   
          818,751 
      
765,635 
         
Premises  and equipment, net
   
            22,527 
      
              22,141 

Accrued  interest receivable
   
              4,598 
      
4,285 

Other  assets
   
            16,882 
      
14,143  

Total  assets
$
    1,052,002 
      
            993,102 
         
LIABILITIES  AND SHAREHOLDERS' EQUITY
         
Liabilities
         
Deposits
         
Noninterest-bearing
$
        130,702 
      
124,489 

Interest-bearing
   
729,029 
      
702,958 

Total  deposits
   
859,731 
      
827,447 
         
Retail  repurchase agreements
   
            19,130 
      
              16,397 

Commercial  paper (Master notes)
   
            17,701 
      
              17,051 

FHLB  borrowings
   
            65,400 
      
              46,000 

Other  liabilities
   
            4,826 
      
 5,445 

Total  liabilities
   
          966,788 
      
            912,340 
         
Commitments  and contingencies (Note 11)
                  
Shareholders'  Equity
         
Common  stock - par value $5.00 per share;  authorized 10,000,000 
         
shares;  issued and outstanding 6,317,285 and 6,297,285
         
at June  30, 2005 and December 31, 2004, respectively.
   
            31,586 
      
31,486 

Capital  surplus
   
                  596 
      
448 

Retained  earnings
   
           52,861 
      
47,923 

Accumulated  other comprehensive income, net of tax
   
                  171 
      
905  

Total  shareholders' equity
   
            85,214 
      
80,762 
         
Total  liabilities and shareholders' equity
$
    1,052,002 
      
993,102 

See Notes to Consolidated Interim Financial Statements

3
 
PALMETTO BANCSHARES, INC. AND  SUBSIDIARY

Consolidated Statements of Income

(dollars in thousands, except  share data) 

For the three months ended June  30,

2005

2004

(unaudited)

Interest  income

Interest  and fees on loans

$
                 14,099 

                   11,232 

Interest  and dividends on investment securities available for sale:

U.S.  Treasury and U.S. Government agencies

                        169 

                           52 

State and  municipal

                        572 

                        570 

Mortgage-backed  securities

                        564 

                        391 

Interest  on federal funds sold

                           34 

                           14 

Dividends  on FHLB stock

                           59 

                           20 

Total  interest income

                   15,497 

                   12,279 

Interest  expense

Interest  on deposits including retail repurchase agreements

                     3,445 

                     2,413 

Interest  on securities sold under agreements to repurchase

and  reverse repurchase agreements

                            -  

                           32 

Interest  on federal funds purchased

                           40 

                           12 

Interest  on FHLB borrowings

                        365 

                           45 

Interest  on commercial paper (Master notes)

                           93 

                           22 

Total  interest expense

                     3,943 

                     2,524 

Net  interest income

                   11,554 

                     9,755 

Provision  for loan losses

                        600 

                        750 

Net  interest income after provision for loan losses

                   10,954 

                     9,005 

Noninterest  income

Service  charges on deposit accounts

                     1,992 

                     2,197 

Net fees  for trust and brokerage services

                        706 

                        768 

Mortgage  banking income

                        474 

                        161 

Investment  securities gains

                           15 

                            -  

Other 

                        788 

                        726 

Total  noninterest income

                     3,975 

                     3,852 

Noninterest  expense

Salaries  and other personnel 

                     5,608 

                     5,049 

Net  occupancy

                        659 

                        598 

Furniture  and equipment

                        920 

                        855 

Marketing  and advertising

                        261 

                        372 

Postage  and supplies

                        315 

                        273 

Telephone

                        183 

                        187 

Professional  services

                        219 

                        226 

Other 

                     1,428 

                     1,194 

Total  noninterest expense

                     9,593 

                     8,754 

Net  income before income taxes

                     5,336 

4,103 

Provision  for income taxes

                     1,788 

                     1,306 

Net  income

$
                   3,548 

                     2,797 

Share  Data:

Net  income - basic

$
                     0.56 

                       0.45 

Net  income - diluted

                       0.55 

                       0.43 

Cash  dividends 

                       0.16 

                       0.14 

Book  value

                     13.49 

                     11.89 

Weighted  average common shares outstanding - basic

             6,314,043 

           6,266,931   

Weighted  average common shares outstanding - diluted

             6,420,995 

             6,381,267 

See Notes to Consolidated Interim Financial Statements

 

4

PALMETTO BANCSHARES, INC. AND  SUBSIDIARY

Consolidated Statements of Income

(dollars in thousands, except  common share data)

For the six months ended June 30,

2005

2004

Interest  income

Interest  and fees on loans
$
          26,990 

            22,503 

Interest  and dividends on investment securities available for sale:

U.S.  Treasury and U.S. Government agencies

                  251 

                  160 

State and  municipal

              1,190 

              1,080 

Mortgage-backed  securities

              1,198 

                  729 

Interest  on federal funds sold

                    55 

                    29 

Dividends  on FHLB stock

                  102 

                    39 

Total  interest income

            29,786 

            24,540 

Interest  expense

Interest  on deposits, including retail repurchase agreements

              6,533 

              4,893 

Interest  on securities sold under agreements to repurchase

and  reverse repurchase agreements

                     -   

                    32 

Interest  on federal funds purchased

                    65 

                    31 

Interest  on FHLB borrowings 

                  662 

                    45 

Interest  on commercial paper (Master notes)

                  159 

                    45 

Total  interest expense

              7,419 

              5,046 

Net  interest income

            22,367 

            19,494 

Provision  for loan losses

              1,200 

              1,500 

Net  interest income after provision for loan losses

            21,167 

            17,994 

Noninterest  income

Service  charges on deposit accounts

              3,839 

              4,280 

Net fees  for trust and brokerage services

              1,458 

              1,438 

Mortgage  banking income

                  756 

                  326 

Investment  securities gains

                    69 

                  108 

Other 

              1,566 

             1,421  

Total  noninterest income

              7,688 

              7,573 

Noninterest  expense

Salaries  and other personnel 

            10,572 

              9,685 

Net  occupancy

              1,259 

              1,189 

Furniture  and equipment

              1,805 

              1,738 

Marketing  and advertising

                  523 

                  586 

Postage  and supplies

                  632 

                  594 

Telephone

                  366 

                  369 

Professional  services

                  400 

                  412 

Other 

              2,835 

              2,427 

Total  noninterest expense

            18,392 

            17,000 

Net  income before income taxes

            10,463 

8,567 

Provision  for income taxes

              3,505 

              2,741 

Net  income
$
            6,958 

              5,826 

Share Data

Net  Income - basic
$
              1.10 

                 0.93 

Net  Income - diluted

                 1.08 

                 0.91 

Cash  dividends 

                 0.32 

                 0.28 

Book  value

              13.49 

              11.89 

Weighted  average common shares outstanding - basic

       6,311,798 

       6,265,500 

Weighted  average common shares outstanding - diluted

       6,418,417 

       6,379,006 
See Notes to Consolidated Interim Financial Statements
5

PALMETTO  BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Cash  Flows 

(in thousands) 
   
For the six months ended June 30,
   
2005

2004

(unaudited)

Cash  flows from operating activities
   
Net  income
$
                  6,958 

                    5,826  

Adjustments  to reconcile net income to net cash 
   
provided  by (used in) operating activities
   
Depreciation  and amortization
   
                    1,664 

2,066  

Investment  securities gains
   
                        (15)

                      (108)

Provision  for loan losses
   
                    1,200 

1,500  

Origination  of loans held for sale
   
                (35,621)

(20,537)

Proceeds  from sale of loans held for sale
   
                  37,071 

23,229  

Gain on  sale of loans
   
                      (616)

(326)

Change in  accrued interest receivable
   
(313)

(22)

Change in  other assets, net
   
(2,131)

(3,039)

Change in  other liabilities, net
   
(619)

669  
   
Net cash  provided by operating activities
   
7,578 

9,258  
   
Cash  flows from investing activities
   
Purchase  of investment securities available for sale
   
                (46,058)

                (60,920)

Proceeds  from maturities of investment securities available for sale
   
                       685 

                    6,287  

Proceeds  from sales and calls of investment securities available for sale
   
                  44,978 

                  15,335  

Principal  paydowns on mortgage-backed securities available for sale
   
                    8,517 

                 12,926 	

Purchase  of Federal Home Loan Bank stock
   
                   (1,473)

                     (254)

Net  increase in loans outstanding
   
                (54,701)

                (28,048)

Purchases  of premises and equipment, net
   
                   (1,371)

                   (1,696)
   
Net cash  used in investing activities
   
                (49,423)

                (56,370)
   
Cash  flows from financing activities
   
Net  increase in deposit accounts
   
32,284 

13,110  

Net  increase in securities sold under agreements to repurchase
   
2,733 

5,265  

Net  increase (decrease) in commercial paper
   
650 

                      (973)

Net decrease  in federal funds purchased
   
                           - 

                   (4,714)

Net  increase in FHLB borrowings
   
                  19,400 

30,000  

Proceeds  from stock option activity
   
                       248 

80 

Dividends  paid
   
                   (2,020)

                   (1,755)
   
Net cash  provided by financing activities
   
53,295 

                  41,013 
   
Net  increase in cash and cash equivalents
   
11,450 

(6,099)

Cash and  cash equivalents, beginning of the period
   
33,445 

33,239 
   
Cash and  cash equivalents, end of the period
$
                44,895 

                  27,140 
   
Supplemental  Information
   
Cash paid  during the period for:
   
Interest  expense
$
                  3,881 

                    5,114 

Income  taxes
   
3,792 

                    2,192 
   
Supplemental schedule of	non-cash  transactions
   
Change in  unrealized gain on investment securities available 
   
for sale,  pretax
$
                (1,193)

                   (2,578)

Loans  transferred to other real estate owned
   
516 

                    1,238 

Loans  charged-off
   
858 

                    1,046 

See Notes to Consolidated Interim Financial Statements

6

PALMETTO BANCSHARES, INC. AND  SUBSIDIARY

 Consolidated Statements of  Changes in Shareholders' Equity and Comprehensive Income 

(dollars in thousands, except  common share data) 

(unaudited)

Accumulated

Shares of

other

common

Common

Capital

Retained

comprehensive

stock

stock

surplus

earnings

income (loss), net

Total

Balance  at December 31, 2003

        6,263,210 

 $    31,316 

 $               250 

 $       39,454 

 $          969 

 $       71,989 

Net  income

             5,826 

             5,826 

Other  comprehensive income, net of tax:

      Unrealized holding gains (losses) arising during period, net

           of tax effect of $951

                (1,519)

      Less:  reclassification adjustment included

           in net income, net of tax effect of $42

(66)

     Net  unrealized gains on securities

           (1,585)

Comprehensive  income

             4,241 

Cash  dividend declared and paid ($0.28 per share)

           (1,755)

           (1,755)

Stock  option activity

                6,325 

32 

48 

 80 

Balance  at June 30, 2004

        6,269,535 

 $    31,348 

 $               298 

 $       43,525 

 $        (616)

 $       74,555 

Balance  at December 31, 2004

        6,297,285 

 $    31,486 

 $               448 

 $       47,923 

 $          905 

 $       80,762 

Net  income

             6,958 

             6,958 

Other  comprehensive income, net of tax:

      Unrealized holding losses arising during period, net

          of  tax effect of $433

(692)

      Less:  reclassification adjustment included

           in net income, net of tax effect of $27

        (42)

     Net  unrealized losses on securities

(734)

Comprehensive  income

6,224 

Cash  dividend declared and paid ($0.32 per share)

(2,020)

(2,020)

Stock  option activity

 20,000 

100 

                     148 

248 

Balance  at June 30, 2005

        6,317,285 

 $    31,586 

 $               596 

 $       52,861 

 $          171 

 $       85,214 
See Notes to Consolidated Interim Financial Statements
7

 

**PALMETTO BANCSHARES, INC.AND SUBSIDIARY****Notes To Consolidated InterimFinancial Statements (unaudited)**

Palmetto Bancshares is a bank holding company headquartered in Laurens, South Carolina and organized in 1982 under the laws of South Carolina. Through its wholly owned subsidiary, The Palmetto Bank (the "Bank"), Palmetto Bancshares, Inc. engages in the general banking business through 31 retail offices in the upstate South Carolina markets of Laurens, Greenville, Spartanburg, Greenwood, Anderson, Cherokee, Abbeville, Pickens, and Oconee counties (the "Upstate"). Brokerage operations are conducted through the Bank's wholly owned subsidiary, Palmetto Capital, Inc. ("Palmetto Capital"). The Bank was organized and chartered under South Carolina law in 1906. Throughout this report, the "Company" shall refer to Palmetto Bancshares, Inc. and its subsidiary, the Bank, which includes its subsidiary, Palmetto Capital, except where the context requires otherwise.

1.  SUMMARY OF SIGNIFICANTACCOUNTING POLICIES

Accountingpolicies followed by the Company for reporting within this quarterly report areconsistent with the accounting policies followed for annual financial reportingwith the exception of the additional accounting policy disclosed below relativeto loan securitizations.  Additionally, the unaudited ConsolidatedInterim Financial Statements included herein are prepared in conformity with the Securities andExchange Commission's instructions for Quarterly Reports on Form 10-Q.Accordingly, certain information and footnotes required by generally acceptedaccounting principles ("GAAP") for complete financial statements are notincluded.  As such, the information contained in this report should be read inconjunction with the financial statements and footnotes included in theCompany's Annual Report on Form 10-K for the year ended December 31, 2004.

LoanSecuritizationsFrom timeto time, the Company packages and sells loan receivables as securities toinvestors. These transactions are recorded as sales in accordance with SFAS No.140, "Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities," when control over these assets has beensurrendered. In conjunction with such transactions, the Company does not retainany interest in the loan or securities other than mortgage-servicing rights.During the second quarter of 2005, the Company securitized and soldapproximately $10 million of its 1-4 family mortgage loans. The gains or lossesassociated with the securitization transaction and the subsequent investmentsecurity sale were reported in the Consolidated Statement of Income for thequarter ended June 30, 2005.

Principles of ConsolidationThe accompanying unauditedConsolidated Interim Financial Statements include the accounts of PalmettoBancshares, Inc., which includes its wholly owned subsidiary, the Bank, and theBank's wholly owned subsidiary, Palmetto Capital. In Management's opinion, allsignificant intercompany accounts and transactions have been eliminated inconsolidation, and all adjustments necessary for a fair presentation of theresults for periods presented have been included.  Any such adjustments are ofa normal and recurring nature. The assets held by the Company in afiduciary or agency capacity for customers are not included in the Company'saudited Consolidated Interim Financial Statements as such items do notrepresent assets of the Company.

Use of EstimatesThe accounting and reporting policies of the Company conform toaccounting principles generally accepted in the United States of America and togeneral practices within the banking industry. In preparing the consolidatedfinancial statements included herein, which are unaudited with the exception ofthose as of the year ended December 31, 2004, Management is required to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities as of the dateof the consolidated financial statements for the periods presented. Actualresults could differ from these estimates and assumptions. As such, the results of operationsfor the three and six month period ended June 30, 2005 are not necessarilyindicative of the results of operations that may be expected in future periods.

 

8

ReclassificationsCertain amounts previously presentedin consolidated financial statements for prior periods have been reclassifiedto conform to current classifications. All such reclassifications had no effecton the prior period net income or retained earnings as previously reported.

RecentlyAdopted Accounting PronouncementsThefollowing is a summary of recent authoritative pronouncements that impactaccounting, reporting, and disclosure of financial information by the Company.

In December2004, the Financial Accounting Standards Board (the "FASB") issued Statement ofFinancial Accounting Standards ("SFAS") No. 123 (revised 2004),"Share-Based Payment."  SFAS No. 123(R) will require companies tomeasure all employee stock-based compensation awards using a fair value methodand record such expense in their financial statements.  In addition, theadoption of SFAS No. 123(R) requires additional accounting and disclosurerelated to the income tax and cash flow effects resulting from share-basedpayment arrangements. For public entities that do notfile as small business issuers, SFAS No. 123(R) was originally scheduledto become effective beginning as of the first interim reporting periodbeginning after June 15, 2005. 

In April 2005, the Securities and ExchangeCommission (the "SEC") deferred the effective date of SFAS No. 123(R) for manyregistrants until the beginning of the first annual period beginning afterJune 15, 2005. The new rule does not otherwise change the application ofStatement 123(R)'s recognition, measurement, disclosure, or transitionprovisions. The Companyis currently evaluating the impact that the adoption of SFAS No. 123(R) willhave on its financial position, results of operations, and cash flows.  Thecumulative impact of adoption, if any, will be measured and recognized in thestatement of operations on the date of adoption.

Alsoduring April 2005, the SEC's Office of the Chief Accountant and its Division ofCorporation Finance released Staff Accounting Bulletin ("SAB") No.107 toprovide guidance regarding the application of FASB Statement No.123 (revised2004).  SAB No. 107 provides interpretive guidance related to the interactionbetween Statement No.123(R) and certain SEC rules and regulations, as well asthe SEC staff's views regarding the valuation of share-based paymentarrangements for public companies.  

In November 2003, the Emerging Issues Task Force ("EITF")reached a consensus that certain quantitative and qualitative disclosuresshould be required for debt and marketable equity securities classified asavailable for sale or held to maturity under SFAS No. 115, "Accounting forCertain Investments in Debt and Equity Securities" and SFAS No. 124, "Accounting forCertain

Investments Held by Not-for-ProfitOrganizations" that areimpaired at the balance sheet date but for which other-than-temporaryimpairment has not been recognized.  Accordingly the EITF issued EITF No. 03-1,"The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments."  This issue addresses the meaning of other-than-temporaryimpairment and its application to investments classified as either availablefor sale or held to maturity under SFAS No. 115 and provides guidance onquantitative and qualitative disclosures.  The disclosure requirements of EITFNo. 03-1 were effective for annual financial statements for fiscal years endingafter June 15, 2004.  The effective date for the measurement and recognitionguidance of EITF No. 03-1 has been delayed.  The FASB staff has issued aproposed Board-directed FASB Staff Position ("FSP"), FSP EITF 03-1-a,"Implementation Guidance for the Application of Paragraph 16 of Issue No.03-1." The proposed FSP would provide implementation guidance with respect todebt securities that are impaired solely due to interest rates and / or sectorspreads and analyzed for other-than-temporary impairment under the measurementand recognition requirements of EITF No. 03-1.  The delay of the effective datefor the measurement and recognition requirements of EITF No. 03-1 will besuperseded concurrent with the final issuance of FSP EITF 03-1-a.  As a resultof the effective date of this guidance being delayed, the Company has notevaluated the impact of the initial adoption of this guidance on the financialcondition or results of operations, if any.

 

9

In May 2005, the FASB issued SFAS No. 154, "AccountingChanges and Error Corrections-a replacement of APB Opinion No. 20 and FASBStatement No. 3."  This Statement replaces Accounting Principles Bulletin("APB") Opinion No. 20,"Accounting Changes," and SFAS No. 3, "Reporting Accounting Changes in InterimFinancial Statements," and changes the requirements for the accounting for andreporting of a voluntary change in accounting principle. It also applies tochanges required by an accounting pronouncement in the unusual instance thatthe pronouncement does not include specific transition provisions. APB No. 20previously required that most voluntary changes in accounting principle berecognized by including in net income of the period of the change thecumulative effect of changing to the new accounting principle. This Statementrequires retrospective application to prior periods' financial statements ofchanges in accounting principle, unless it is impracticable to determine eitherthe period-specific effects or the cumulative effect of the change. When it isimpracticable to determine the period-specific effects of an accounting changeon one or more individual prior periods presented, this Statement requires thatthe new accounting principle be applied to the balances of assets andliabilities as of the beginning of the earliest period for which retrospectiveapplication is practicable and that a corresponding adjustment be made to theopening balance of retained earnings (or other appropriate components of equityor net assets in the statement of financial position) for that period ratherthan being reported in an income statement. When it is impracticable todetermine the cumulative effect of applying a change in accounting principle toall prior periods, this Statement requires that the new accounting principle beapplied as if it were adopted prospectively from the earliest date practicable.This Statement carries forward without change the guidance contained in APB No.20 for reporting the correction of an error in previously issued financialstatements and a change in accounting estimate. This Statement also carriesforward the guidance in APB No. 20 requiring justification of a change inaccounting principle on the basis of preferability. Theadoption of SFAS No. 154 had no material impact on the Company's financialcondition or results of operations.

Other accounting standards that have been issued or proposedby the FASB or other standards-setting bodies that do not require adoptionuntil a future date are not expected to have a material impact on theconsolidated financial statements upon adoption.

2.       NATURE OFOPERATIONS

The industry in which the Bank operates exists primarily toprovide an intermediary service to the general public with funds to depositand, by using these funds, to originate loans in the markets served. The Bankprovides a full range of banking activities, including, but not limited to,checking, savings, money market, and other time deposits for a wide range ofconsumer and commercial depositors, loans for business, real estate, andpersonal uses, safe deposit box rental, electronic funds transfer services,telephone banking, and bank card services. The Bank's indirect lendingdepartment establishes relationships with Upstate automobile dealers to providecustomer financing on qualifying automobile purchases, and its mortgage-bankingoperation meets a range of customers' financial service needs by originating,selling, and servicing mortgage loans. The Bank also offers both individual andcommercial trust services. Palmetto Capital offers customers stocks, treasuryand municipal bonds, mutual funds, and insurance annuities, as well as collegeand retirement planning through an affiliated company.

3.      INVESTMENT SECURITIESAVAILABLE FOR SALE

The tables set forth below summarizethe amortized cost, gross unrealized gains, gross unrealized losses, and fairmarket values of investment securities available for sale at the datesindicated (in thousands).

10

June 30, 2005
			 
Amortized cost

Unrealized 			gains

Unrealized 			losses

Fair value

United  States Government agencies
$
28,939 

13 

(80)

          28,872 

State and  municipal 
			 
                      62,551 

                      942 

                    (433)

        63,060 

Mortgage-backed  
			 
42,352 

85 

(248)

          			42,189 

Total 
$
133,842 

1,040 

(761)

         134,121 
			 
December 31, 2004
			 
Amortized cost

Unrealized gains

Unrealized losses

Fair value

United  States Government agencies
$
10,053 

         			6  			

(38)

            10,021 

State and  municipal 
			 
68,198 

                   1,629 

            (331)

 69,496 

Mortgage-backed  
			 
64,010 

277 

(71)

           64,216 

Total 
$
142,261 

1,912 

                    (440)

       143,733 
			 
From December 31, 2004 to June 30,2005, the investment securities portfolio experienced a shift frommortgage-backed securities to United States Government agencies.  This shiftreflects the Company's goal of having an investment securities portfolioconcentrated on total return as funds from the sale of mortgage-backedsecurities were reinvested into agencies that had a better total return profileat the time of execution.  The decline in the total investment securitiesportfolio of approximately 7% from December 31, 2004 to June 30, 2005 is primarilyattributed to cash flow resulting from mortgage-backed security prepayments andpaydowns being used to fund the Company's loan portfolio growth.

Investment securities available forsale were impacted by purchases, securitizations, proceeds from the sale,maturity, and / or call of such securities as well as principal paydowns ofmortgage-backed securities, which is reflected in the Consolidated Statement ofCash Flows. During the three month period ended June 30, 2005, the Company hadrealized gains of $264 thousand and realized losses amounting to $249 thousandon sales of investment securities available for sale compared with no realizedgains or losses during the three month period ended June 30, 2004. For the sixmonth period ended June 30, 2005, the Company had realized gains of $382thousand and realized losses amounting to $313 thousand on sales of investmentsecurities available for sale compared with realized gains of $141 thousand andrealized losses amounting to $33 thousand during the six month period endedJune 30, 2004. Specific identification is the basis on which cost is determinedin computing realized gains and losses.

Most mortgage-backed investmentsecurities are either fully backed or sponsored by the United States Governmentand provide income with less risk than other investment options. In addition,generally such investments are traded actively, so liquidity risk is minimal.Management believes that the unrealized losses on investment securities wereattributable to increases in interest rates, rather than credit quality. Sincethe Company has the ability and intent to hold these investments until a marketprice recovery or maturity, Management does not consider these investments tobe other-than-temporarily impaired.

At June 30, 2005 investment securitiesavailable for sale totaling $102.6 million were pledged and $62.3 million werebeing utilized to secure public deposits, securities sold under agreements torepurchase, and for other purposes as required or permitted by law.

4.      LOANS 

The table set forth below summarizesloans, excluding those mortgage loans held for sale, by classification at thedates indicated (dollars in thousands).

 

11

June 30, 2005

December 31, 2004
			 
Total

% of Total

Total

% of Total

Commercial  business
$
                  90,828 

11.1%

                      90,708 

11.8 

Commercial  real estate
			 
537,058 

               65.6 

                   478,943 

62.6 

Installment
			 
17,835 

                 2.2  			

19,910 

2.6 

Installment  real estate
			 
52,678 

                  6.4 

51,846 

6.8 

Indirect
			 
25,590 

                   3.1 

16,383  

2.1 

Credit  line
			 
1,900 

                  0.2 

2,012 

0.3 

Prime  access
			 
51,387 

                  6.3 

45,655 

5.9 

Residential  mortgage
			 
35,080 

                  4.3 

52,669 

6.9 

Bankcards
			 
10,480 

                   1.3 

10,930 

 1.4 

Business  manager
			 
419 

                   0.1 

552 

0.1 

Other
			 
1,888  

                  0.2 

1,473 

0.2 

Gross  Loans
$
                 825,143 

100.8%

771,081 

100.7 

Allowance  for loan losses
			 
                       (8,051)

                 (1.0)

                       (7,619)

                 (1.0)

Loans in  Process
			 
1,073 

                   0.1 

1,470 

0.2 

Deferred  Loans Fees and costs
			 
                           586 

                   0.1 

703 

0.1 

Loans, net
$
                 818,751 

100.0%

                   765,635 

100.0 
			 
Loans included in the table are net ofwhole loans, participations sold, and mortgage loans serviced for others.Mortgage loans serviced for the benefit of others amounted to $294.1 millionand $265.7 million at June 30, 2005 and December 31, 2004, respectively. Mostof these mortgage loans are serviced for the Federal Home Loan MortgageCorporation.

As reflected in the table above,material fluctuations were experienced in the commercial real estate, indirectlending, and residential mortgage portfolios.  

Management has continued its emphasison loans secured by real estate during the first six months of 2005 asManagement believes such loans involve less inherent risk than those secured bycollateral other than real estate or loans that are unsecured. Managementbelieves that this growth is due to the Company's capitalization on goodcommercial real estate opportunities in the Company's market.  From December31, 2004 to June 30, 2005, the commercial real estate portfolio grew by $58.1million, or 12.1%.

During the first six months of 2005,the Company's indirect lending portfolio increased $9.2 million, or 56.2%. Management attributes this automobile loan growth to a new program offered bythe Company that targets high scoring consumers at competitive rates. The goalof this program is to first introduce the Company and its products to reputableautomobile dealers.  Once introduced, the Company's goal is to continue tobuild and maintain relationships with these dealers.  

The residential mortgage loan portfolio decreased $17.6million, or 33.4%, during the first six months of 2005.  Residential mortgageloan originations during this period were offset by prepayments as well as aloan securitization and loan sales during the second quarter of 2005 totalingapproximately $14 million.  As noted above, during the second quarter of 2005,the Company securitized and sold approximately $10 million of its 1-4 familymortgage loans. Thegoal of this securitization was to provide enhanced liquidity resources,improve capital ratios, and to provide growth in revenues from off-balancesheet servicing activities. In addition to this securitization, approximately $4 million residentialmortgage loans were sold during the second quarter of 2005 from the loansreceivable portfolio.  

The table set forth below summarizesnonaccrual loans and loans past due 90 days and still accruing interest at thedates indicated (in thousands).
			 
June 30,

December 31,
			 
2005

2004

Nonaccrual  loans
$
               2,343 

                       2,323 

Loans past  due 90 days and still accruing (1)
			 
                      224 

                           147 
$
               2,567 

                       2,470 
			 
(1)  Substantially all of these loans are bankcard loans.

As of June 30, 2005, Management wasaware of no potential problem loans that were not already categorized asnonaccrual, past due, or restructured, that had borrower credit problemscausing Management to have serious doubt as to the ability of the borrower tocomply with the present loan repayment terms.

 

12

The table set forth below summarizesthe activity impacting the allowance for loan losses (the "Allowance") for theperiods indicated (in thousands).

For the three months ended

For the six months ended

June 30,

June 30,
			 
2005

2004

2005

2004

Balance,  beginning of period
$
                  7,838 

                    7,692 

                     7,619 

                    7,463 

Provision  for loan losses
			 
                        600 

                        750 

                     1,200 

                     1,500 
			 						 
Loans  charged-off
			 
                        455 

                        477 

                      858  			

                     1,046 

Loan  recoveries
			 
                          68 

                           18 

                          90 

                          66 

     Net  charged off loans
			 
                        387 

                        459 

                        768 

                        980 
			 						 
Balance,  end of period
$
                  8,051 

                    7,983 

                     8,051 

                    7,983 
			 
The Allowance balance remained relatively unchanged when comparing the three and six month periods ended June 30, 2004 to the same periods of 2005 although the provision for loan losses declined when comparing both periods primarily as a result of increasing credit quality.  In an effort to mitigate any credit deterioration resulting from economic conditions, Management has and continues to emphasize conservative underwriting in an effort to manage credit quality. Classified assets at June 30, 2005 were relatively unchanged from June 30, 2004 and December 31, 2003.  Although classified assets increased at June 30, 2005 over December 31, 2004 Management believes that this increase was due to the fact that classified assets were at levels not necessarily indicative of credit quality trends at December 31, 2004.  Comparing classified assets to the other periods noted above gives a better picture of the Company's historical levels of classified assets.  From these levels, classified assets remained relatively unchanged at June 30, 2005. Additionally, net loans charged-off during the three month period ended June 30, 2005 totaled $387 thousand, down from $459 thousand during the three month period ended June 30, 2004. Net loans charged-off during the six month period ended June 30, 2005 totaled $768 thousand, down from $980 thousand during the six month period ended June 30, 2004. Also contributing to the relatively unchanged balance of the Allowance from June 30, 2004 to June 30, 2005 was a declining trend in nonperforming assets over the periods.  Nonperforming assets declined from $3.0 million at June 30, 2004 to $2.3 million at both December 31, 2004 and June 30, 2005. These factors were offset slightly by the impact of the growth of the loan portfolio over the periods.

SFAS No. 15, "Accounting by Debtorsand Creditors for Troubled Debt Restructurings," establishes standards offinancial accounting and reporting by the debtor and by the creditor for atroubled debt restructuring. This Statement requires adjustments in paymentterms from a troubled debt restructuring generally to be considered adjustmentsof the yield (effective interest rate) of the loan. So long as the aggregatepayments (both principal and interest) to be received by the creditor are notless than the creditor's carrying amount of the loan, the creditor recognizesno loss, only a lower yield over the term of the restructured debt. Similarly,the debtor recognizes no gain unless the aggregate future payments (includingamounts contingently payable) are less than the debtor's recorded liability.Any troubled debt restructurings entered into by the Company for the periodended June 30, 2005 were immaterial when considered individually, or in theaggregate, with regard to the Company's Consolidated Financial Statements.

The Company makes contractualcommitments to extend credit, which are legally binding agreements to lendmoney to customers at predetermined interest rates for a specific period oftime. The Bank also provides standby letters of credit. See Note 11 for adiscussion of the Company's lending commitments.

 

13

The Company's primary market area isthe Upstate region of South Carolina. Management closely monitors its creditconcentrations and attempts to diversify the portfolio within its primarymarket area. At June 30, 2005, except for the concentration of a majority ofthe loan portfolio in the Company's primary market area, there were noconcentrations of loans in any type of industry, type of property, or to oneborrower.

5.      MORTGAGE-SERVICINGRIGHTS

The Company originates, sells, andservices mortgage loans. All of the Company's loan sales have been withoutprovision for recourse. Mortgage loans serviced for the benefit of othersamounted to $294.1 million, $265.7 million, and $269.6 million at June 30,2005, December 31, 2004, and June 30, 2004, respectively. As previouslydiscussed, during thesecond quarter of 2005, the Company securitized and sold approximately $10million of its 1-4 family mortgage loans and sold approximately $4 millionresidential mortgage loans from the loans receivable portfolio, in addition toits loan sales in the ordinary course of business.  Both of the second quartertransactions were executed with mortgage-servicing rights retained. In additionto these two transactions, the increase in mortgage loans serviced for the benefitof others can be contributed to the decline in mortgage loan payoffs over priorperiods due to the increasing interest rate environment.  

The table set forth below summarizesthe changes in the carrying amount of capitalized mortgage-servicing rights,which are included in other assets, for the periods indicated (in thousands).

For the three months ended 			June 30,

For the six months ended 			June  30,
 
2005

2004

2005

2004

Mortgage-servicing  rights, beginning of period
			$
              2,358			

2,478			

2,316			

2,567			

Capitalized  mortgage-servicing rights
 
364			

113			

526			

263			

Amortization
 
(199)

(131)

(337)

(320)

Change in  valuation allowance
 
25			

(69)

43			

(119)

Total mortgage-servicing  rights, end of period
			$
              2,548			

2,391			

2,548			

2,391			
  
The aggregate fair market value ofmortgage-servicing rights at both June 30, 2005 and 2004 was $2.5 million and$2.2 million, respectively.

The table set forth below summarizesthe activity impacting the valuation allowance for impairment of mortgage-servicing rights, which isincluded in other assets, for the periods indicated (in thousands).

For the three months ended			June 30,

For the six months ended 			June 30,
			 
2005

2004

2005

2004

Valuation  allowance, beginning of period
$
                  114			

    90			

132			

                      40			

Aggregate  additions charged and reductions credited to operations
			 
                     (25)

                       69			

(43)

                     119			

Valuation  allowance, end of period
$
                    89			

   159			

 89			

                    159			
			 
Activity impacting the Company'smortgage-servicing right portfolio, including mortgage loans originated to besold and sales, are reflected in the Consolidated Statement of Cash Flows.

Capitalized mortgage-servicing rightshave increased for both the three and six month periods ended June 30, 2005over the same periods of 2004 due in part to the increase in mortgage loansales in the normal course of business during those periods.  Also contributingto this increase for both the three and six month periods ended June 30, 2005over the same periods of 2004 were $142 thousand of mortgage-servicing rights retained andcapitalized in conjunction with the loan securitization and sales during thesecond quarter of 2005 from loans receivable.

 

14

As a resultof the flattening yield curve, fixed rate loans become more impaired asprepayment speeds increase. Additionally, fifteen year fixed rate loans becomemore impaired than thirty year fixed rate loans due to the shorter duration.Prepayment speeds increased during the three and six month periods ended June30, 2005, in part due to the loan securitization during the three month periodended June 30, 2005, thereby impacting mortgage-servicing right impairment forthat period.

As reported in the Company's Annual Report on Form 10-K forthe year ended December 31, 2004, estimated amortization and impairment expenserelated to mortgage-servicing rights is $620 thousand for the year endedDecember 31, 2005, $485 thousand for the year ended December 31, 2006, $376thousand for the year ended December 31, 2007, $289 thousand for the year endedDecember 31, 2008, $220 thousand for the year ended December 31, 2009, and atotal of $203 thousand in years thereafter. Management is aware of no materialevents or uncertainties that would cause reported expenses related tomortgage-servicing rights not to be indicative of future operating results orfuture financial condition or that would cause future operating results orfuture financial condition to differ material from these projections. However, amortization expense iscalculated based on current available information regarding loan payments andprepayments and could change in future periods based on changes in volume ofprepayments and economic factors.

6.       OTHER INTANGIBLE ASSETS

The table set forth below summarizesintangible assets, net of accumulated amortization, which are included in otherassets, at the dates indicated (in thousands).
		 
June 30,

December 31,
		 
2005

2004

Finite  life intangible assets
		 
Intangible  assets from branch acquisitions
$
                  247		

                     320		
		 
Infinite  life intangible assets
		 
Intangible  assets from branch acquisitions
		 
                   3,691 

                   3,691 
 		 		 		 		 Total other intangible assets$3,9384,011
The table set forth below summarizesthe activity of intangible assets with finite lives, which are comprised ofcustomer list intangibles and are included in other assets, and the relatedamortization for the years indicated (in thousands).

For the three months ended June 30,

For the six months ended June 30,
 
2005

2004

2005

2004

Balance,  beginning of period
$
283			

 428			

               320			

             464			

Amortization
 
       (36)

      (36)

     (73)

     (72)

Balance,  end of period
$
247			

392			

247			

   392			
 
There wereno changes in the carrying amount of goodwill for the three or six monthperiods ended June 30, 2005.

As reported in the Company's Annual Report on Form 10-K forthe year ended December 31, 2004, estimated amortization expense related to finitelived intangibles is $144 thousand for the year ended December 31, 2005, $48thousand for the years ended December 31, 2006 and 2007, $45 thousand for theyear ended December 31, 2008, and $33 thousand for the year ended December 31,2009. Management is aware of no material events or uncertainties that wouldcause reported expenses related to intangible assets not to be indicative offuture operating results or future financial condition or that would causefuture operating results or future financial condition to differ material from theseprojections. 

TheCompany's infinite life intangible assets are subject to periodic impairmenttests that are performed by the Company as of June 30 annually, or more often,if events or circumstances indicate that there may be impairment. The valuationas of June 30, 2005 indicated that no impairment charge was required as of thattest date. There have been no events or circumstances since June 30, 2005 thatindicate there may be impairment. 

 
15****
7.       DEPOSITS

The table set forth below summarizesdeposits, by type, at the dates indicated (in thousands).
 
June 30,

December 31,
 
2005

2004

Transaction  deposit  accounts 
$
            322,775 

                   309,561 

Savings  deposit accounts
 
                 50,275 

                     44,972 

Money  market deposit accounts
 
                  118,815 

                     95,608 

Time  deposit accounts
 
               367,866 

                  377,306 

     Total
$
            859,731			

                  827,447 
 
8.      BORROWINGSFROM THE FEDERAL HOME LOAN BANK

At June 30, 2005, of itsapproximately $221 million available credit based on qualifying loans availableto serve as collateral against borrowings from the FHLB, the Company employed$65.4 million in short-term and long-term borrowings. Of this balance at June30, 2005, $23 million was long-term.  

9.      EMPLOYEE BENEFITPLANS

Postretirement BenefitsThe table set forth below summarizesthe combined adjusted postretirement benefit expense components for theCompany's noncontributory defined benefit pension plan for the periodsindicated (in thousands). 

For the three months ended 			June 30,

For the six months ended 			June 30,
			 
2005

2004

2005

2004

Service  cost
$
                  346			

119			

                   487			

                   267			

Interest  cost
			 
                     392			

139			

                   557			

                   302			

Expected  return on plan assets
			 
                   (586)

(183)

                  (815)

                 (397)

Amortization  of prior service cost
			 
5

2

                         8 

4

Amortization  of net loss
			 
58

17

                       78 

37

Net  periodic benefit cost
$
                    215 

                        94 

                     315 

                     213 
			 
The Company expects to contribute $1.2million to the plan during 2005. During the three and six month periods endedJune 30, 2005, $300 thousand and $623 thousand was contributed, respectively.

Stock Option PlanAt June 30, 2005, the Company had a stock-based employee anddirector option plan, which is described more fully in Note 13 of Notes toConsolidated Financial Statements included in its Annual Report on Form 10-Kfor the year ended December 31, 2004.  Prior to its revision inDecember 2004, SFAS No. 123, "Accounting for Stock-Based Compensation," alloweda company to either adopt the fair market value method of valuation or continueusing the intrinsic valuation method presented under APB Opinion No. 25 toaccount for stock-based compensation. SFAS No. 123 permitted companies torecognize as expense over the vesting period the fair market value of allstock-based awards on the date of grant. In Management's opinion, the existingstock option valuation models did not necessarily provide a reliable singlemeasure of stock option fair market value. Therefore, as permitted, the Companyhas applied the existing accounting rules under APB Opinion No. 25 and providedproforma net income and proforma earnings per common share disclosures foremployee stock option grants as if the fair market value based method definedin SFAS No. 123 had been applied. In accordance with the provisions of APB OpinionNo. 25 and related interpretations, which requires compensation expense foroptions be recognized only if the market price of the underlying stock exceedsthe exercise price on the date of grant, no compensation expense was recognizedfor stock options granted during the three or six month periods ended June 30,2005 and 2004.

The table set forth below summarizesthe impact the fair market value recognition provisions of SFAS No. 123 wouldhave had on net income and earnings per common share if the Company has appliedthese provisions to stock-based employee compensation for the periods indicated(in thousands, except share data).

16

For the three months ended 			June 30,

For the six months ended    						June 30,
 
2005

2004

2005

2004

Net income, as reported
$
    3,548 

2,797 

6,958 

         			5,826 

Deduct: Total stock-based employee			and director compensation
 
expense determined under fair			value-based methods for all 
 
awards, net of related tax effects
 
 24 

                     			34 

48 

                     			67 

Pro forma net income
$
      3,524			

2,763 

 6,910 

           			5,759 
 
Earnings per share
 
Basic  - as reported
$
   0.56 

0.45 

 1.10 

    0.93 

Basic - pro forma
 
 0.56 

 0.44 

  1.09 

     0.92 
 
Diluted - as reported
$
   0.55 

 0.43 

1.08 

    0.91 

Diluted - pro forma
 
   0.55 

 0.43 

1.08 

    0.90 

The Company did not grant any optionsduring the second quarter of 2004 or 2005.  34,000 options were granted duringthe first quarter of 2004 and 33,000 options during the same period of 2005.The weighted average fair value of options granted approximated $5.22 and $4.18,respectively. The fair value of each option granted is estimated on the date ofgrant using the Black-Scholes option-pricing model with the followingweighted-average assumptions used for grants during 2004 and 2005,respectively: dividend yield of 2.4% and 2.6%, expected volatility of 18% and10%, average risk-free interest rate of 4% for grants during both years,expected lives of 10 years, and a vesting period of five years. 

The table set forth below summarizesstock option activity for the 1997 Stock Compensation Plan for the periodindicated.

Stock options
 
Weighted-average				exercise price

Outstanding  at December 31, 2003

                261,510 
$
                 12.95 

Granted

                 34,000 
 
                   23.30 

Forfeited

                           -   
 
                          -   

Exercised

                 (6,325)
 
                    12.74 

Outstanding  at June 30, 2004

               289,185 
$
                  14.17 
 
Outstanding  at December 31, 2004

             257,835  		
$
                 14.59 

Granted

                 33,000 
 
                   26.60 

Forfeited

                           -   
 
                          -   

Exercised

               (20,000)
 
                    12.44 

Outstanding  at June 30, 2005

              270,835 
$
                 16.22 
 
In December 2004, the FASBpublished SFAS No. 123 (revised), "Share-Based Payment*.*" SFASNo.123(R) was designed to provideinvestors and other users of financial statements with more complete andneutral financial information by requiring that the compensation cost relatingto share-based payment transactions be recognized in financial statements. Thatcost will be measured based on the fair market value of the equity or liabilityinstruments issued. The Company will be required to apply SFAS No. 123(R) as ofthe first annual reporting period that begins after June 15, 2005. Until thetime of adoption, the Company will continue to comply with the requirements ofthe original SFAS No. 123 as amended in December 2002.

 

17

10.   NET INCOME PER COMMON SHARE

Basic anddiluted earnings per share have been computed based on net income presented inthe accompanying Consolidated Statements of Income divided by the weighted averagecommon shares outstanding or assumed to be outstanding as summarized below:

For the three months ended June 30,

For the six months ended June 30,

2005

2004

2005

2004

Basic  weighted average number of common shares outstanding 

        6,314,043			

6,266,931			

  6,311,798			

6,265,500			

Dilutive  effect arising from potential common share issuances

 106,952			

 114,336			

    106,619			

113,506			

Diluted  weighted average number of common shares outstanding

6,420,995			

6,381,267			

6,418,417			

 6,379,006			

Optionshares are excluded from the calculation of diluted earnings when the exerciseprice is greater than the average market price of the common shares as of thatdate.  At June 30, 2005 and 2004, there were no option shares that wereexcluded from the calculation of diluted earnings, based on informationavailable to Management at that time.

The Companypaid cash dividends of $0.16 per share for the quarter ended June 30, 2005 and$0.14 per share for the same quarter of 2004.  Cash dividends for the six monthperiods ended June 30, 2005 and 2004, respectively were $0.32 and $0.28 pershare.

11.  COMMITMENTS ANDCONTINGENCIES

Legal ProceedingsThe Company is currently subjectto various legal proceedings and claims that have arisen in the ordinary courseof its business. In the opinion of Management based on consultation withexternal legal counsel, any reasonably foreseeable outcome of such currentlitigation would not materially affect the Company's consolidated financialcondition or results of operations.

Lending CommitmentsThe tableset forth below summarizes the Company's contractual commitments to extendcredit at June 30, 2005 (in thousands).

Home  equity loans
$
             44,028  		

Credit  cards
		 
44,610 

Commercial  real estate development
		 
 79,057 

Other  unused lines of credit
		 
34,510 

     Total  contractural commitments to extend credit
$
            202,205 
		 
Standby letters of creditrepresent an obligation of the Company to a third party contingent upon thefailure of the Company's customer to perform under the terms of an underlyingcontract with the third party or an obligation of the Company to guarantee orstand as surety for the benefit of the third party. At June 30, 2005, theCompany recorded no liability for the current carrying amount of the obligationto perform as a guarantor, and no contingent liability was considerednecessary, as such amounts were not considered material. The maximum potentialamount of undiscounted future payments related to standby letters of credit atJune 30, 2005 was $1.9 million. Past experience indicates that many of thesestandby letters of credit will expire unused. However, through its varioussources of liquidity, the Company believes that it has the necessary resourcesto meet these obligations should the need arise. Additionally, the Company doesnot believe that the current fair market values of such guarantees werematerial at June 30, 2005.

Other Off-Balance Sheet ArrangementsAt June 30, 2005, the Company had nointerests in nonconsolidated special purpose entities nor is it involved in other off-balancesheet contractual relationships (other than those discussed herein),unconsolidated related entities that have off-balance sheet arrangements, ortransactions that could result in liquidity needs.

12.  DERIVATIVEFINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

Derivativetransactions may be used by the Company to better manage its interest ratesensitivity to reduce risks associated with its lending, deposit taking, andborrowing activities. Statement of Financial Accounting Standards No. 133,"Accounting for Derivative Instruments and Hedging Activities,"("SFAS 133") as amended by SFAS Nos. 137, 138 and 149, establishesaccounting and reporting standards for derivatives and hedging activities. SFASNo. 133 requires an entity to recognize all derivatives as either assets orliabilities in the balance sheet, and to measure those instruments at fairvalue. Changes in the fair value of those derivatives are reported in currentearnings or other comprehensive income depending on the purpose for which thederivative is held and whether the derivative qualifies for hedge accounting.The Company does not currently engage in any activities that qualify for hedgeaccounting under SFAS No. 133. All changes in the fair value of derivativeinstruments are recorded as non-interest income in the consolidated statementsof operations.

 

18

 

The Companyhas identified the following derivative instruments at June 30, 2005:commitments to originate certain residential loans held for sale and forwardsales commitments.

The Companyoriginates certain residential loans with the intention of selling these loans.Between the time that the Company enters into an interest rate lock or acommitment to originate a fixed rate residential loan with a potential borrowerand the time the closed loan is sold, the Company is subject to variability inmarket prices. The Company believes that it is prudent to limit the variabilityof expected proceeds from the sales through forward sales of loans("forward sales commitments"). 

Outstanding commitments on mortgage loans not yet closed amounted toapproximately $8.3 million at June 30, 2005. The fair value of derivative assets related tocommitments to originate such residential loans held for sale and forward salescommitments was not significant at June 30, 2005.

13.  REGULATORYCAPITAL REQUIREMENTS

The ability of the Company topay cash dividends over the long-term is dependent upon receiving cash in theform of dividends from its subsidiary, the Bank. South Carolina's bankingregulations restrict the amount of dividends that the Bank can pay. Alldividends paid from the Bank are payable only from the net income of thecurrent year, unless prior regulatory approval is granted. Capital adequacyconsiderations could further limit the availability of dividends from the Bank.

The Company and the Bank aresubject to various regulatory capital requirements administered by the Federalbanking agencies. If the Company or the Bank fails to meet minimum capitalrequirements, regulators can take certain mandatory and discretionary actionsthat, if undertaken, could have a material effect on the Company's ConsolidatedFinancial Statements. Under capital adequacy guidelines and the regulatoryframework for prompt corrective action, the Company and the Bank must meetspecific capital guidelines that involve quantitative measures of the assets,liabilities, and certain off-balance sheet items as calculated under regulatoryaccounting practices. The Company's and the Bank's capital amounts andclassification are also subject to qualitative judgments by the regulatorsabout components, risk-weightings, and other factors. Quantitative measuresestablished by regulation to ensure capital adequacy require the Company andthe Bank to maintain minimum amounts and ratios (set forth in the followingtable) of total and Tier 1 capital (as defined in the regulations) torisk-weighted assets (as defined in the regulations) and to average assets (asdefined in the regulations).

At June 30, 2005, the most recentnotification from federal banking agencies categorized the Company and the Bankas "well capitalized" under the regulatory framework. To be categorized as"well capitalized," minimum total risk-based capital, Tier 1 capital, and Tier1 leverage ratios as set forth in the table below (dollars in thousands) mustbe maintained. Since June 30, 2005, there have been no events or conditionsthat Management believes have changed these categories.

 

19

                                                                                                                            
          To be	well           	capitalized under        
For capital  prompt	corrective   Actual  adequacy purposes  
action provisions   amount ratio  amount ratio  amount ratio At June30, 2005               *Totalcapital to risk-weighted assets*                  The Company$ 88,901 10.18% $  69,864 8.00%  N/A N/A    The Bank 88,157 10.09  69,864 8.00 $  87,330 10.00%                 *Tier 1 capital to risk-weighted assets*               
   The Company$80,850 9.26% $34,932 4.00% N/A N/A 
   The Bank80,106 9.17 34,932 4.00 $52,398 6.00%              *Tier 1 capital to average assets*                  The Company$80,850 7.76% $41,699 4.00%  N/A N/A    The Bank 80,106 7.68  41,711 4.00 $52,139 5.00%                 At December 31, 2004               *Total capital to risk-weighted assets*                  The Company$83,234 10.33% $64,434 8.00%  N/A N/A    The Bank 82,739 10.27  64,434 8.00 $80,542 10.00%                 *Tier 1 capital to risk-weighted assets*                  The Company$75,615 9.39% $32,217 4.00%  N/A N/A    The Bank 75,120 9.33  32,217 4.00 $48,325 6.00%                 *Tier 1 capital to average assets*                  The Company$75,615 7.76% $38,994 4.00%  N/A N/A    The Bank 75,120 7.70  39,005 4.00 $48,757 5.00% 
The Bank's total capital to risk-weighted assets ratiodeclined from 10.27% at December 31, 2004 to 10.09% at June 30, 2005 primarily due to the growth of 100%risk weighed assets at a rate faster than that of risk based capital.  TheCompany's 2005 Profit Plan projected that total loans would grow by $55.9million during 2005.  Total loans grew by $52.6 million during the first sixmonths of 2005.  However, risk based capital did not experience the samepercentage of growth during the same period thereby negatively impacting the totalcapital to risk-weighted assets ratio.  Management does not believe that theseconditions give rise to concern regarding the ratio due to the fact thatManagement expects that loan growth will continue to increase toward the 2005Profit Plan amount during the second six months of 2005, but at a slower pacethan during the first six months of 2005.  As risk based capital continues toincrease toward the 2005 Profit Plan amount and as the pace of loan growthslows, the Bank's total capital to risk-weighted assets ratio will return tobalances typical for the Bank. Management is currently exploring options foradjustments to ensure the Bank remains in a  "well-capitalized" position. 

*** ***

20

**Item 2. Management's Discussion and Analysis of Financial Condition and Results ofOperations**

Thefollowing discussion and analysis is presented to assist in understanding thefinancial condition and results of operations of the Company.  This discussionshould be read in conjunction with the consolidated financial statements andrelated notes and other financial data appearing in this report as well as inthe Company's Annual Report on Form 10-K for the year ended December 31, 2004. Results of operations for the three and six month periods ended June 30, 2005are not necessarily indicative of results that may be attained for any otherperiod.  Percentage calculations contained herein have been calculated basedupon actual, not rounded, results.

WEBSITEAVAILABILITY OF REPORTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION

The Bank'swebsite, www.palmettobank.com, includes a link to the Securities and ExchangeCommission's Electronic Data Gathering, Analysis, and Retrieval ("EDGAR")system which makes various reports filed with the Securities and ExchangeCommission by the Company, including, but not limited to, its Annual Report onForm 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K,Ownership Reports filed in conjunction with Section 16, and amendments to suchreports, available, free of charge.  These reports are made available as soon asreasonably practicable after these reports are filed with, or furnished to, theSecurities and Exchange Commission.  The Securities and Exchange Commission'sEDGAR database may also be accessed through its website, www.sec.gov.

FORWARD-LOOKINGSTATEMENTS

The Company makes forward-lookingstatements in this report and in other reports and proxy statements filed withthe SEC. In addition, certain statements in future filings by the Company withthe Securities and Exchange Commission, in press releases, and in oral andwritten statements made by or with the approval of the Company, which are notstatements of historical fact, constitute forward-looking statements. Broadlyspeaking, forward-looking statements include, but are not limited to,projections of the Company's revenues, income, earnings per common share,capital expenditures, dividends, capital structure, or other financial items,descriptions of plans or objectives of Management for future operations,products or services, forecasts of the Company's future economic performance,and descriptions of assumptions underlying or relating to any of the foregoing.

Forward-looking statements discussmatters that are not historical facts. Because such statements discuss futureevents or conditions, forward-looking statements often include words such as"anticipate," "believe," "estimate," "expect," "intend," "plan," "project,""target," "can," "could," "may," "should," "will," "would," or similarexpressions. Do not unduly rely on forward-looking statements. Such statementsgive expectations about the Company's future and are not guarantees.Forward-looking statements speak only as of the date for which they are made,and the Company might not update them to reflect changes that occur after thedate they are made.

There are several factors, many beyondthe Company's control, that could cause results to differ significantly fromexpectations. Some of these factors include, but are not limited to,
- risks from changes in economic,     monetary policy, and industry conditions;
- changes in interest rates,     deposit rates, the net interest margin, and funding sources;
- market risk and inflation;
- risks inherent in making loans,     including repayment risks and value of collateral;
- loan growth;
- the adequacy of the allowance for     loan losses (the "Allowance") and the assessment of classified loans;
- the ability of the Company to     meet its contractual obligations;
- fluctuations in consumer     spending;
- competition in the banking     industry and demand for the Company's products and services;

 

 

21
- dependence on Senior Management;
- technological changes;
- ability to increase market share;     
- expense projections;
- risks associated with income     taxes, including the potential for adverse adjustments;
- changes in accounting policies     and practices;
- costs and impact of litigation;     and
- recently-enacted or proposed     legislation.

Many of these factors, as well asother factors, such as credit, market, operational, liquidity, interest rate,and other risks, are discussed in more detail in the Company's Annual Report onForm 10-K for the year ended December 31, 2004. Any factor described in thisQuarterly Report on Form 10-Q or in that Annual Report on Form 10-K could byitself, or together with one or more factors, adversely affect the business,financial condition, and / or results of operations of the Company.Additionally, there are factors that may not be described in this report thatcould cause actual results to differ from expectations.

COMPANY OVERVIEW

Palmetto Bancshares is a bank holding company organized under the laws of South Carolina in 1982. The Palmetto Bank (the "Bank"), a wholly owned subsidiary of the holding company, was organized and chartered under South Carolina law in 1906. The Company's corporate offices are located at 301 Hillcrest Drive, Laurens, South Carolina. The Bank is a full-service bank and trust company. At June 30, 2005, the Bank had thirty-one full-service offices in the Upstate region of South Carolina within the following counties: Laurens County (4), Greenville County (10), Spartanburg County (5), Greenwood County (5), Anderson County (3), Cherokee County (2), Pickens County (1), and Oconee County (1). In addition to retail offices, at June 30, 2005, the Bank had 30 ATM locations (including three at nonretail office locations) and five-limited service offices located in retirement centers in the Upstate. The Bank engages in investment services through its wholly owned subsidiary, Palmetto Capital, Inc. ("Palmetto Capital"). Throughout this report, the "Company" shall refer to Palmetto Bancshares, Inc. and its subsidiary, the Bank, which includes its subsidiary, Palmetto Capital, except where the context requires otherwise.

The Company's primary market area islocated within South Carolina in the foothills region of Greenville, including Greenville Countyand its surrounding counties. Primary business sectors in the region includebanking and finance, manufacturing, health care, retail, telecommunications,government services, and education. The Company believes that it is not dependenton any one or a few types of commerce due to the area's diverse economic base.

Management continually reviews opportunities for Upstateexpansion that it believes to be in the best interest of the Company, itscustomers, and its shareholders. Expansion opportunities are currently beingevaluated in the market areas in which the Company currently serves. During thesecond quarter of 2004, the Company closed on a real estate site in Easley,South Carolina that will introduce the Company's presence into Pickens County. Easley is a culturally diversecommunity with approximately 20,000 residents living within the city limits. Maintaining the Company's focus onserving Upstate South Carolina, ground was broken on the new office in Easleyin December 2004, with the office opening scheduled for third quarter 2005. Atemporary office is being utilized in Easley from which the Company isconducting preliminary planning and branch operations until the retail officeopens.  

The business of the Company consists primarily of acting asa financial intermediary by attracting deposits from the general public andusing such funds, together with borrowings and other funds, to originate loanslocated in its primary market areas. The Company also invests in investmentsecurities. Through its direct subsidiary and the subsidiary of the Bank, theCompany also engages in full-service brokerage activities and trust andfiduciary services.

 

22

SECOND QUARTER HIGHLIGHTS

At June 30, 2005, the Company's assetstotaled $1.1 billion, an increase of $58.9 million or 5.9% over December 31,2004. The increase in assets during the first six months of 2005 resultedprimarily from an increase in total loans of $52.6 million. Average assetsincreased 13.9% in 2005 over the same period of 2004.  Over the same period,average interest-earning assets increased 14.3%. Total liabilities increased$54.4 million, or 6.0%, at June 30, 2005 over December 31, 2004, to a balanceof $966.8 million. This increase resulted primarily from increases in interest-bearingdeposit accounts and FHLB borrowings over the same periods. Total deposits andother borrowings were $962.0 million at June 30, 2005, up from $906.9 millionat December 31, 2004. Total shareholders' equity at June 30, 2005 totaled $85.2million, an increase of $4.5 million over December 31, 2004.

Net income for the quarter ended June 30, 2005 increased 26.9% to $3.5 million from net income of $2.8 million in the comparable quarter in fiscal 2004. Basic earnings per common share increased to $0.56 per common share for the quarter ended June 30, 2005 compared to $0.45 per common share for the quarter ended June 30, 2004. On a diluted basis, earnings per common share increased to $0.55 from $0.43 in the comparable period.

On a comparative basis, net interest income increased $1.8 million, or 18.4%, between the quarters ended June 30, 2005 and June 30, 2004. The Company's net interest margin in the quarter ended June 30, 2005 increased to 4.72% compared with 4.59% during the quarter ended June 30, 2004. The Company's average earning assets increased $126.4 million between the quarters ended June 30, 2005 and 2004.

Net income during the quarter ended June 30, 2005 in comparison to the same quarter ended June 30, 2004 increased by $751 thousand. Noninterest income was $4.0 million for the second quarter of 2005, increasing by $123 thousand, or 3.2%, over the comparable quarter last year. Mortgage-banking income comprised 11.9% of total noninterest income in the current quarter and increased $313 thousand, or 194.4%, from the comparable quarter ended June 30, 2004. The increase was principally related to higher gains on sales of mortgage loans that were attributed to increased sales over the periods noted as well as a loan securitization during the second quarter of 2005.  This increase in mortgage-banking income was partially offset by declines in service charges on deposit accounts.  Service charges on deposit accounts decreased $205 thousand, or 9.3%, during the quarter ended June 30, 2005 when compared with the same quarter of 2004. The decline in service charges on deposit accounts is primarily related to nonsufficient funds and overdraft service charge declines due to customers' increased used of the Company's overdraft protection program as well as an increase in alternative transaction methods such as debit cards.  This increased use of debit cards has decreased the Company's service charge opportunities, since transactions that would otherwise result in overdrafts are typically declined by the merchant.

Total noninterest expense increased by 9.6%, or $839 thousand, during the quarter ended June 30, 2005 compared with the comparable quarter ended June 30, 2004. Salaries and other personnel expenses were higher in the current quarter, increasing by $559 thousand, due to the increased staffing for new positions and the new Easley office and from adjustments for annual merit increases and other benefit programs.

CRITICAL ACCOUNTING POLICIES

The Company's accounting and financialreporting policies are in conformity with generally accepted accountingprinciples ("GAAP") and with general practice within the banking industry. Thepreparation of financial statements in conformity with such principles requiresManagement to make estimates and assumptions that impact the reported amountsof assets and liabilities, the disclosure of contingent assets and liabilitiesat the date of the financial statements, and the reported amounts of revenuesand expenses during the reporting period. During the annual financial reportingprocess, Management, in conjunction with the Company's independent auditors,discusses the development and selection of the critical accounting estimateswith the Audit Committee of the Board of Directors.  Additionally, the AuditCommittee reviews the Company's Quarterly Reports on Form 10-Q and the AnnualReports on Form 10-K including all related disclosures.

23

The Company's significant accountingpolicies are discussed in Item 8, Note 1 of Notes to Consolidated FinancialStatements of its Annual Report on Form 10-K for the year ended December 31,2004. Of these significant accounting policies, the Company considers itspolicies regarding the accounting for the Allowance, pension plan,mortgage-servicing rights, accounting for past acquisitions, and income taxes,to be its most critical accounting policies due to the valuation techniquesused and the sensitivity of these financial statement amounts to the methods,assumptions, and estimates underlying these balances. Accounting for thesecritical areas requires a significant degree of judgment that could be subjectto revision as newer information becomes available. In order to determine theCompany's critical accounting policies, Management considers if the accountingestimate requires assumptions about matters that were highly uncertain at thetime the accounting estimate was made and if different estimates thatreasonably could have been used in the current period, or changes in theaccounting estimate that are reasonably likely to occur from period to period,would have a material impact on the presentation of financial condition,changes in financial condition, or results of operations.

FINANCIAL CONDITION

InvestmentSecurities PortfolioThe securities portfolio, all of whichis classified as available for sale, is a component of the Company'sasset-liability management strategy. Securities available for sale areaccounted for at fair value, with unrealized gains and losses recorded net oftax as a component of other comprehensive income in shareholders' equity. Athird party determines the fair value of the securities portfolio. Thevaluation is determined as of the date of the end of the reporting period basedon available quoted market prices or quoted market prices for similarsecurities if a quoted market price is not available.

Investment securities available forsale, excluding FHLB capital stock, totaled $134.1 million at June 30, 2005, adecrease of $9.6 million, or 6.7%, over December 31, 2004. 

The table set forth below summarizes theCompany's investment securities available for sale composition at the datesindicated (dollars in thousands).

June 30, 2005

December 31, 2004
		 
Total

% of Total

Total

% of Total

United  States Government agencies
$
28,872 

21.5%

        10,021 

                 7.0 

State and  municipalities
		 
63,060 

      47.0 

69,496 

48.3 
Mortgage-backed		 42,18931.5 64,21644.7   Total$ 134,121100.0% 143,733100.0
See Consolidated Statements of CashFlows contained herein for a summary of how purchases, securitizations,proceeds from the sale, maturities, and / or calls of such investmentsecurities as well as principal paydowns of mortgage-backed securities impactedthe investment securities available for sale portfolio during the six monthperiod ended June 30, 2005.

At June 30, 2005, the investment securities portfoliodeclined slightly to 12.7% of total assets from 14.5% at December 31, 2004. TheCompany was in a gross unrealized gain position on securities available forsale at June 30, 2005 of $279 thousand compared to a gross realized gainposition of $1.5 million at December 31, 2004. At June 30, 2005, the Governmentagencies portfolio was in an unrealized loss position of $67 thousand, themunicipal portfolio had an unrealized gain position of $509 thousand, and themortgage-backed securities portfolio had an unrealized loss position of $163thousand.  Typically, a rising interest rate environment negatively impacts theyield curve for the securities available for sale portfolio thereby impactingthe unrealized position of the portfolio negatively.  

24

The weighted average life and duration of the securitiesportfolio is maintained to limit overall exposure and to provide flexibility toproactively manage cash flow as market conditions change. The averageweighted life of the Company's securities available for sale portfolio was 3.61years at June 30, 2005 up from 3.60 years at December 31, 2004. Managementattributes the slight increase in duration to the continued decline in prepaymentsof mortgage-backed securities due to rising interest rates.  

Average balances of available for saleinvestment securities, excluding FHLB capital stock, increased to $140.0million for the first six months of 2005 compared with $134.9 million for theyear ended December 31, 2004.  The average portfolio yield, including the unrealized gain or loss onavailable for sale securities, increased for the six month period ended June30, 2005 to 3.80% from 3.46% for the year ended December 31, 2004. The averageportfolio yield, including the unrealized gain or loss on available for salesecurities, for the six month period ended June 30, 2004 was 3.27%. Theincreasing yield trend can be contributed to the increase in average taxableinvestment securities over the periods presented which typically earn a higherreturn than nontaxable investment securities.  For the three month period endedJune 30, 2005 taxable investment securities increased $11.7 million and theyield on these securities increased 110 basis points over the three monthperiod ended June 30, 2004.  For the six month period ended June 30, 2005taxable investment securities increased $13.2 million and the yield on thesesecurities increased 100 basis points over the six month period ended June 30,2004.  

Inaccordance with the Company's investment policy, all investment securities mustbe rated AA - A in order to minimize credit risk. At June 30, 2005, while allsecurity ratings were in compliance with the policy guidelines, approximately55% of the securities portfolio was rated AAA, either by Standard and Poors orMoody's, which constitutes the highest credit worthiness.  Additionally, atJune 30, 2005, the entire MBS portfolio was fixed rate.

Loans Held for SaleLoans held for sale consists primarilyof 15 and 30 year mortgages which the Company intends to sell as whole loans.Loans held for sale are carried at the lower of aggregate cost or fair marketvalue. The fair value of mortgage loans held for sale is based on the fairmarket value for such outstanding commitments to sell these loans. Typically,the carrying amount approximates fair value due to the Company's practice oftypically selling these loans within 30 days of origination. Loans held forsale were $4.9 million and $5.9 million at June 30, 2005 and December 31, 2004,respectively. Loans held for sale were impacted by originations and salesactivity, which are reflected in the Consolidated Statement of Cash Flows. Novaluation allowance to reduce these loans to lower of cost or fair market valuewas required at June 30, 2005 or December 31, 2004.

Loan PortfolioGeneral. As loans represent the mostsignificant component of interest-earning assets, the Company strives tomaintain a diversified loan portfolio in an effort to spread risk and reduceexposure to economic downturns that may occur within different segments of theeconomy, geographic locations, or in particular industries. The loan portfolio consistsprincipally of commercial loans, commercial real estate loans, consumer loans,indirect dealer loans, and mortgage loans. The loan portfolio is diversified, andthe Bank's business is not dependent on any single customer or industry, or afew customers or industries. Although loans may be originated outside of SouthCarolina, the majority of the loan portfolio is originated in the market areaof Upstate, South Carolina. Certain risks are inherent within any loanportfolio.  For a discussion of characteristics of the loan portfolio,including such risks, see the Company's Annual Report on Form 10-K for the yearended December 31, 2004.  

At June 30,2005, loans outstanding, excluding mortgage loans held for sale, were $826.8million, or 79% of total assets.  Total loans outstanding at December 31, 2004totaled $773.3 million, or 78% of total assets. See Note 4 of Item 1, FinancialStatements for a discussion regarding loan composition, excluding thosemortgage loans held for sale, by classification.

25
Credit Quality. The table set forthbelow summarizes the classified assets at the dates indicated (in thousands). 		 
June 30,

December 31,
		 
2005

2004

Special  mention
$
5,539 

                 3,209 

Substandard
		 
 10,566 

     10,569 

Doubtful
		 
   1,236 

 1,582 

Loss
		 
           1 

            1 

Total  classified assets
$
 17,342 

           15,361 
 
Management believes that the increase in special mention classified assets at June 30, 2005 over December 31, 2004 does not indicate a deterioration of asset quality as the increase can be attributed, for the most part, to isolated loan circumstances.  The remaining classified asset portfolios remained relatively unchanged from over the two periods noted. 

The Company's loan portfolio isperiodically reviewed and loans are, in the opinion of Management,appropriately classified, and Allowances have been established against allassets requiring classification. 

The table set forth below summarizestrends in problem assets and other asset quality indicators at the datesindicated (dollars in thousands).
		 
June 30,

December 31,
   		 
2005

2004
   
Nonaccrual  loans
$
              2,343 

                 2,323 
   
Real  estate acquired in settlement of loans
		 
                 2,323 

                  2,413 
   
Repossessed  automobiles
		 
                  180 

                  282 
   
Total  nonperforming assets
		 
                 4,846 

                  5,018 
   
Loans past  due 90 days and still accruing (1)
		 
                  224 

              147 
   
Total  nonperforming assets and loans past due 90 days and still accruing
$
              5,070 

                  5,165 
       
Ending  loans (2)
$
      826,802 

         773,254 
   
Nonaccrual  loans as a percentage of loans (2)
		 
                      0.28 

%

                      0.30 
   
Nonperforming  assets as a percentage of
    
total  assets
		 
 0.46 

%

                0.51 
   
Allowance  for loan losses to nonaccrual loans
		 
3.44 

 x 

                      3.28 
       
(1)

  Substantially  all of these loans are bankcard loans
   
(2)

  Calculated  using loans excluding mortgage loans held for sale, net of unearned,  excluding the Allowance

Although it appears that the overall United States economy has begun to gain strength, markets served by the Company experienced variability in terms of unemployment rates, bankruptcy filings, and delinquency rates. In an effort to mitigate any credit deterioration resulting from economic conditions, Management continues to emphasize conservative underwriting in an effort to manage credit quality. As a result, credit quality trends have remained relatively unchanged since year-end 2004. 

As the table set forth belowindicates, the composition of nonaccrual loans remained relatively unchangedfrom December 31, 2004 to June 30, 2005 (dollars in thousands).

June 30, 2005

December 31, 2004
		 
Total

% of Total

Total

% of Total
Loans  secured by real estate$ 1,840        78.5  % 1,705        73.4 Commercial		      388       16.6      353       15.2 Credit  cards		 -    		       -         10     0.4 Other  consumer		  115      4.9     255       11.0 Total  nonaccrual loans$    2,343      100.0  %     2,323     100.0  	 
26

** **

Based on information available toManagement at June 30, 2005, real estate and automobiles acquired as a resultof repossession, foreclosure, or by deed in lieu of foreclosure were recordedat the lower of cost or estimated fair market value less cost to sell. 

Management believes that theproperties within the real estate acquired in settlement of loans portfolio aremarketable and that continued improvement within both the local and nationaleconomy will positively impact the sale of the remaining properties within theportfolio.  Management also believes that consumers' ability to better servicetheir debt resulted in the Company's relatively low additions to real estateacquired in settlement of loans during the first six months of 2005. 

As of June 30, 2005, Management wasaware of no potential problem loans that were not already categorized asnonaccrual, past due, or restructured that had borrower credit problems causingManagement to have serious doubt as to the ability of the borrower to complywith the present loan repayment terms.

Any troubled debt restructuringsentered into by the Company for the three and six month periods ended June 30,2005 were immaterial when considered individually, or in the aggregate, withregard to the Company's unaudited Consolidated Interim Financial Statements.

While the Company believes thatcurrent economic data suggests that the United States economy is improving, thepace of that improvement is difficult to predict and credit quality indicatorsremain unpredictable. Management believes, however, that because the Company'sloan portfolio is closely monitored, changes are promptly addressed in itsanalysis of Allowance adequacy. Additionally, Management believes that there willalways remain a core level of delinquent loans and real estate and personalproperty acquired in settlement of loans from normal lending operations. 

Allowance for Loan Losses The Company provides for loan losses on the allowancemethod. Accordingly, all loan losses are charged to the Allowance and allrecoveries are credited to the Allowance. Additions to the Allowance areprovided by charges to operations based on various factors, which, inManagement's judgment, deserve current recognition in estimating losses. Suchfactors considered by Management include the value of the underlyingcollateral, growth and composition of the loan portfolios, loss experience, andeconomic conditions. Management evaluates the carrying value of loansperiodically and the Allowance is adjusted accordingly. While Management usesthe best information available to make evaluations, future adjustments to theAllowance may be necessary if economic conditions differ substantially from theassumptions used in making the evaluations. The Allowance is subject toperiodic evaluation by various regulatory authorities and may be subject toadjustment upon their examination.

The Allowance totaled $8.1 million and$7.6 million at June 30, 2005 and December 31, 2004, respectively representing0.97% and 0.99% of loans, less mortgage loans held for sale, for the sameperiods. 

The fair market value of mortgageloans held for sale is based on prices for outstanding commitments to sellthese loans. Typically, the carrying amount approximates fair market value dueto the short-term nature of these instruments. Likewise, such instruments arenot included in the assumptions related to the Allowance model.

27
The table set forth below summarizesthe activity in the Allowance at the dates and for the periods indicated(dollars in thousands). Losses and recoveries are charged or credited to theAllowance at the time realized.
 

At and for the six months ended

For the year ended

June 30,

December 31,
		 
2005

2004

2004

Balance,  beginning of period
$
7,619 

7,463 

7,463 

Provision  for loan losses
		 
1,200 

1,500 

2,150 
 
Loans  charged-off
		 
858 

1,046 

2,150 

Loan  recoveries
		 
(90)

(66)

(156)

Net loans  charged-off
		 
768 

980 

1,994 
 
Balance,  end of period
$
8,051 

7,983 

7,619 
 
Loans (1)
$
826,802 

719,043 

773,254 

Average  loans (1)
		 
807,453 

705,893 

725,555 

Net  charge-offs to average loans (annualized) (1)
		 
0.19% 

0.28 

0.27 

Allowance  for loan losses to loans
		 
0.97 

1.11 

0.99 
 
(1)

Calculated  using loans excluding mortgage loans held for sale, net of unearned,  excluding the Allowance
 
See Note 4 of Notes to unauditedConsolidated Interim Financial Statements contained herein for a discussionregarding the relatively unchanged Allowance balance from June 30, 2004 to June30, 2005. In addition, for discussion of the decline in the provision for loanlosses over the periods presented, see Earnings Review Comparison-Provision forLoan Losses.

The table set forth below summarizesthe activity of total loans charged-off for the periods indicated (inthousands). 

For the six months ended

June 30,
		 
2005

2004

Secured by  1-4 family residential properties
$
                      124 

                         108 

Secured by  multifamily residential properties
		 
                              1 

                            -   

Secured by  nonfarm nonresidential properties
		 
                            11 

                         132 

Commercial  and industrial
		 
                         180 

                         195 

Credit  cards
		 
                         221 

                       206  		

Other  consumer
		 
                         231 

                        339 
$
                     768 

                        980 
 
Net loans charged-offs decreased whencomparing the six month period ended June 30, 2005 to the same period endedJune 30, 2004.  This fluctuation was impacted primarily by decreases in loanscharged-off secured by nonfarm nonresidential properties and other consumerloans.  Management believes that the decrease in net loanscharged-off can be attributed to customers' ability to service their debt aswell as Management's conservative approach to and management of loan quality.

Based on the current economicenvironment and other factors that impact the assessment of the Company'sAllowance as discussed above, Management believes that the Allowance at June30, 2005 was maintained at a level adequate to provide for estimated probablelosses in the loan portfolio. However, assessing the adequacy of the Allowanceis a process that requires considerable judgment. Management's judgments arebased on numerous assumptions, which it believes to be reasonable, but whichmay or may not prove to be accurate. Thus, there can be no assurance that loanlosses in future periods will not exceed the current Allowance amount or thatfuture increases in the Allowance will not be required. No assurance can begiven that Management's ongoing evaluation of the loan portfolio, in light ofchanging economic conditions and other relevant circumstances, will not requiresignificant future additions to the Allowance, thus adversely impacting theresults of operations of the Company.

28

DepositsRetail deposits have traditionally been the primary sourceof funds for the Company and also provide a customer base for the sale ofadditional financial products and services. The Company faces stiff competition from other banking andfinancial services companies in gathering deposits. 

Traditional deposit accounts, whichinclude noninterest-bearingand interest-bearing transaction, money market, savings, and time depositaccounts, increased $32.3 million during the first six months of 2005. At June 30,2005, traditional deposits as a percentage of liabilities were 89.0% comparedwith 90.7% at December 31, 2004.  The table set forth below summarizes the Company's depositcomposition at the dates indicated (dollars in thousands).

June 30, 2005

December 31, 2004
		 
Total

% of Total

Total

% of Total

Transaction  deposit accounts
$
     322,775 

              37.6 

%

              309,561  		

              37.4 

Money  market deposit accounts
		 
118,815 

       13.8 

                  95,608 

      11.6 

Savings  deposit accounts
		 
50,275 

     5.8 

44,972  		

     5.4 
Time deposit accounts		 367,86642.8 377,30645.6     Total$859,731100.0%827,447100.0
Core deposits, which includetransaction, money market, and savings deposit accounts, grew by $41.7 millionduring the first six months of 2005. This increase in core deposits resultedfrom programs and deposit promotions offered during the period. This increasewas also impacted by the Company's continued ability to attract depositsthrough pricing adjustments, expansion of its geographic market area, providingquality customer service, and through the Company's reputation among thecommunities it serves. 

Time deposit accounts decreased by$9.4 million during the first six months of 2005. Promotional certificate of depositaccounts offered beginning during early 2002 began to mature during the firstsix months of 2005.  The Bank has successfully retained a large portion ofthese maturing funds.  The decline in time deposits during the first six monthsof 2005 is due in large part to the funds that the Bank was unable to retain. 

The Company's increase in coredeposits reflects its efforts to enhance its deposit mix by working to attractlower-cost deposit accounts. As noted above, core deposits grew by $41.7million during the first six months of 2005 while higher-cost time balancesdecreased by $9.4 million during the same period. The Company's average cost ofcore deposits for the six month period ended June 30, 2005 was 0.67% comparedwith 0.33% for the same period ended June 30, 2004. The Company's average costof core deposits for the year ended December 31, 2004 was 0.36%.  The Company'saverage cost of time deposits for the six month period ended June 30, 2005 was2.84% compared with 2.51% for the same period ended June 30, 2004. TheCompany's average cost of time deposits for the year ended December 31, 2004was 2.56%.  

BorrowingsBorrowings increased $22.8 millionduring the first six months of 2005. This increase was primarily attributed to an increasedreliance on borrowings to support interest-earning asset growth. The table setforth below summarizes the Company's borrowings composition at the datesindicated (dollars in thousands).

June 30, 2005

December 31, 2004
		 
Total

% of Total

Total

% of Total

Retail  repurchase agreements
$
          19,130 

18.7%

            16,397 

               20.6  		

Commercial  paper
		 
             17,701 

                 17.3 

             17,051 

                 21.5 

FHLB  borrowings
		 
           65,400 

                64.0 

           46,000 

                57.9 

Total  borrowings
$
      102,231  		

100.0%

           79,448 

              100.0 
               
29

At June 30, 2005, of its approximately$221 million available credit based on qualifying loans available to serve ascollateral against borrowings from the FHLB, the Company employed $65.4 millionin borrowings, $23.0 million of which constituted long-term debt. The Companydid not take any additional long-term advances during the three or six monthperiods ended June 30, 2005.  The increase in FHLB borrowings over this periodwas due to an increase in short-term borrowings.  As noted above, the increasein short-term borrowings was used to fund growth in interest-earning assets. 

The tableset forth below summarizes the Company's average borrowing costs for theperiods indicated.

For the six months ended

For the year ended

June 30,		

December 31,

2005

2004

2004

Retail  repurchase agreements 

                    1.87 

%

 0.50 

0.61 

Commercial  paper

                    1.82 

0.59 

0.75 

Federal  funds purchased

                    2.61 

1.27 

1.51 

FHLB  borrowings

                   2.36 

3.22 

2.98 

Security  repurchase agreement

                        -   

1.28 

1.27 

With the exception of interest paid onFHLB advances, borrowings costs have increased during the six month periodended June 30, 2005 over both the six month period ended June 30, 2004 and theyear ended December 31, 2004.  One main reason for the increases in the ratespaid on interest-bearing liabilities has been the action of the Federal ReserveOpen Market Committee (the "Committee"). On June 30, 2005, the Committee raised the federalfunds rate by 25 basis points to 3.25 percent. This increase was the ninth suchincrease since the Fed began to tighten credit in June 2004 in an effort tocontrol inflation.

Borrowing costs relative to FHLB borrowings have declinedover the periods noted.  The main reason for this decline is that during thesix month period ended June 30, 2004, the Company utilized $30.0 million oflong-term FHLB advances with an average cost of 3.22%.  During the second halfof 2004, the Company also began to employ short-term FHLB borrowings thatgenerally cost less than long-term advances.  These lower costing short-termborrowings reduced the average borrowing cost for all FHLB borrowings,including short-term and long-term.  Of the $65.4 million of outstanding FHLBborrowings at June 30, 2005, only $23.0 million were long-term advances while$42.4 million were lower costing short-term borrowings.  

Capital ResourcesThe objective of effective capitalmanagement is to generate above market returns on equity to shareholders whilemaintaining adequate regulatory capital ratios. The Company uses capital tofund growth, pay dividends, and, from time to time, repurchase its commonstock.

Shareholders'equity totaled $85.2 million and $80.8 million at June 30, 2005 and December31, 2004, respectively.  Shareholders' equity as a percentage of total assetswas 8.1% at June 30, 2005 and December 31, 2004.  During thefirst six months of 2005, shareholders' equity was impacted by the retention ofearnings, the payment of cash dividends, stock option activity, andfluctuations in the unrealized position on investment securities available forsale. The Consolidated Statements of Changes in Shareholders' Equity andComprehensive Income****contained herein provides detail of the changes instockholders' equity components during the first six months of 2005.

The Company and the Bank are requiredto meet regulatory capital requirements, which currently include severalmeasures of capital. At June 30, 2005, the Company and the Bank were eachcategorized as "well capitalized" under the regulatory framework for promptcorrective action. For further discussion of the Bank's and the Company'scapital regulatory requirements, see Note 13 of Notes to unaudited ConsolidatedInterim Financial Statements contained herein. 

The Bank's total capital to risk-weighted assets ratiodeclined from 10.27% at December 31, 2004 to 10.09% at June 30, 2005 primarily due to the growth of 100%risk weighed assets at a rate faster than that of risk based capital.  TheCompany's 2005 Profit Plan projected that total loans would grow by $55.9million during 2005.  Total loans grew by $52.6 million during the first sixmonths of 2005.  However, risk based capital did not experience the samepercentage of growth during the same period thereby negatively impacting the totalcapital to risk-weighted assets ratio.  Management does not believe that theseconditions give rise to concern regarding the ratio due to the fact thatManagement expects that loan growth will continue to increase toward the 2005Profit Plan amount during the second six months of 2005, but at a slower pacethan during the first six months of 2005.  As risk based capital continues toincrease toward the 2005 Profit Plan amount and as the pace of loan growthslows, the Bank's total capital to risk-weighted assets ratio will return tobalances typical for the Bank. Management is currently exploring options foradjustments to ensure the Bank remains in a  "well-capitalized" position. 

30

 

During the first six months of 2005,the dividend payout ratio was 29.0% compared with a payout ratio of 30.1%during the same period of 2004. For the year ended December 31, 2004 thedividend payout ratio was 30.1%. Cash dividends per share for the three monthperiod ended June 30, 2005 totaled $0.16, an increase over dividends per sharefor the same quarter of 2004 of $0.14. Cash dividends per share for the sixmonth period ended June 30, 2005 totaled $0.32, an increase over dividends pershare for the same quarter of 2004 of $0.28. 

The Company's bookvalue per share was $13.49 at June 30, 2005 compared with $12.82 at December31, 2004.  

For discussion of the unrealized position on available forsale securities, see Note 3 of Notes to unaudited Consolidated InterimFinancial Statements contained herein. 

DISCLOSURESREGARDING MARKET RISK

As of June 30, 2005, Management believes that there havebeen no significant changes in market risk as disclosed in the Company's AnnualReport on Form 10-K for the year ended December 31, 2004.

One tool the Company utilizes in assessing asset-liability management isa simulation model that is used to analyze interest sensitivity gap (thedifference between the amount of interest-sensitive assets maturing orrepricing within a specific time period and the amount of interest-sensitiveliabilities maturing or repricing within the same time period). The Company'sgap position, while not a complete measure of interest sensitivity, is reviewedperiodically to provide insights related to the static repricing structure ofthe Company's assets and liabilities. 

The following table is a summary of the Company's one-year interestsensitivity gap(dollars in thousands):

 
		 
June		30, 2005
Interest-earning assets maturing orrepricing within one year
$ 506,556 
         Interest-bearing liabilities maturing or repricingwithin one year 
		 (719,772)
Cumulative gap        
$(213,216)
Gap as a percentage of total assets   
		 20.3% 
Based on the Company's June 30, 2005 gap position in aone-year time period, $506.6 million in interest-earning assets will repriceand approximately $719.8 million in interest-bearing liabilities will reprice.This current dynamic gap position results in a negative one-year gap positionof $213.2 million, or 20.3% of assets. 

An important aspect of achievingsatisfactory net interest income is the composition and maturities ofrate-sensitive assets and liabilities. It must be understood, however, that thestatic gap position is limited because it does not take into account changes ininterest rates or changes in Management's expectations or intentions. Inaddition, such an analysis is as of the date noted. 

Therefore, theCompany employs another important process to evaluate how interest-sensitiveassets and liabilities are impacted by changes in interest rates or selectedindices as they reprice. The Asset Liability-Committee reviews asset-liabilitymodeling monthly to assess varying interest rate and balance sheet mixassumptions. This asset-liability modeling simulates the Company's ConsolidatedBalance Sheets and Consolidated Statements of Income under several differentinterest rate scenarios over a twelve-month period. This modeling analyzes from a base rate scenario,assuming no change in rates, variations that occur when rates graduallyincrease and decrease in increments of 100 basis points up to 300 basis pointsover the coming twelve-month period. Computation of prospective effects ofhypothetical interest rate changes are based on numerous assumptions, includingrelative levels of market interest rates, and loan prepayments, and should not berelied upon as indicative of actual results. Further, the computations do notcontemplate any actions the Company could undertake in response to changes ininterest rates.

 

31

According to the model at June 30,2005, if interest rates rose by 300 basis points over the coming twelve-month period, net interestincome would be adversely impacted by approximately $4.0 million, or 8.3%. Thismodel also shows that if interest rates rose by 100 or 200 basis points overthe coming twelve-month period, net interest income would be adversely impactedby approximately $436 thousand, or 0.9%, and $2.1 million, or 4.4%,respectively. The model also shows that if interest rates dropped 300 basispoints over the coming twelve month period, net interest income would beadversely impacted by approximately $4.7 million, or 9.7%. If interest ratesdropped by 200 points over the coming twelve-month period, net interest incomewould be negatively impacted by approximately $2.1 million, or 4.4%. Ifinterest rates dropped by 100 points over the coming twelve-month period, netinterest income would be positively impacted by approximately $173 thousand, or0.4%. Current parameters and guidelines of the Company's Asset Liability Management Committee includemaintaining the projected impact on the Company's net interest income for thetwelve-month period at an amount not to exceed 20%. The projected impact on theCompany's net interest income for the twelve-month period does not exceed the20% threshold prescribed by the Asset Liability Management Committee's policy.

LIQUIDITY

GeneralManagement determines the desiredlevel of liquidity for the Company in conjunction with the Company'sAsset-Liability Committee. The level of liquidity is based on Management'sstrategy for the Company, commitments to make loans, and the Committee'sassessment of the Company's ability to generate funds.

Proper liquidity management is crucialto ensure that the Company is able to take advantage of new businessopportunities as well as meet the demands of its customers. In this process,the Company focuses on assets and liabilities and on the manner in which theycombine to provide adequate liquidity to meet the Company's needs.

The Company's liquidity is impacted byits ability to attract and retain deposit accounts, activity within and salesfrom its investment securities and loan portfolios, alternative sources offunds, and current earnings. Competition for deposits is intense in the marketsserved by the Company. The Company believes that it, historically, has beenable to attract deposits as needed through pricing adjustments, expansion ofits geographic market area, providing quality customer service, and through theCompany's reputation among the communities it serves. The deposit base iscomprised of diversified customer deposits with no one deposit or type ofcustomer accounting for a significant portion. Therefore, the Company does notexpect that withdrawals will fluctuate from historical levels in the near term.The loan portfolio of the Company is a source of liquidity through maturitiesand repayments by existing borrowers. Loan demand has been relatively constant,and loan originations can be controlled through pricing decisions. Theinvestment securities portfolio is also an avenue for liquidity throughscheduled maturities, sales of investment securities, and prepayment ofprincipal on mortgage-backed securities.

Each of the Company's sources of liquidity is subject tovarious uncertainties beyond the control of the Company. As a measure ofprotection, the Company has back-up sources of funds available. If needed,alternative funding sources have been arranged through federal funds lines atcorrespondent banks and through the Federal Reserve Discount Window. At June30, 2005, the Company had unused short-term lines of credit throughcorrespondent banks totaling of $40.0 million (which are withdrawable at theCompany's option).

In addition to these unused short-termlines of credit, the Company may utilize borrowings from the FHLB to fundincreases in interest-earning assets in times of declines in alternativefunding sources. FHLB borrowings are an alternative to other funding sourceswith similar maturities. The FHLB has an overall credit limit for each member.The FHLB allows securities, qualifying loans, deposits, and stock of the FHLBowned by the Company to be pledged to secure any advances from the FHLB. AtJune 30, 2005, of its approximately $221 million available credit based onqualifying loans available to serve as collateral against borrowings from theFHLB, the Company employed $65.4 million in both short-term and long-termborrowings.

32

At June 30, 2005 investment securitiesavailable for sale totaling $102.6 million were pledged and $62.3 million werebeing utilized to secure public deposits, securities sold under agreements torepurchase, and for other purposes as required or permitted by law.

Management believes that all of theabove liquidity sources provide the capacity for the Company to meet futurefunding demands. These sources are available should deposit cash flows andother funding be reduced in any given period.    

To review factors that impactedliquidity for the six month period ended June 30, 2005, see Consolidated Statements of Cash Flowcontained herein. 

Palmetto BancsharesThe holding company conducts itsbusiness through its banking subsidiary by offering commercial paper as analternative investment tool for its commercial customers (master note program).The commercial paper is issued only in conjunction with the automated sweepaccount customer agreement on deposits at the Bank level. At June 30, 2005, theholding company had $17.7 million in commercial paper with a weighted averagerate paid during the year of 1.82%, as compared to $17.1 million at December31, 2004 with a weighted average paid during the year of 0.75%.

Potential sources for the holdingcompany's payment for its periodic stock purchases and dividends include dividendsfrom the Bank and funds received through stock option exercises. At June 30,2005, the holding company had cash reserves of $744 thousand compared with $495thousand at December 31, 2004. The increase between the two periods is dueprimarily to the receipt of funds in conjunction with stock option transactionsduring the first six months of 2005.

Current federal law prohibits, exceptunder certain circumstances and with prior regulatory approval, an insureddepository institution, such as the Bank, from paying dividends or making anyother capital distribution if, after making the payment or distribution, theinstitution would be considered "undercapitalized," as that term is defined inapplicable regulations. In addition, as a South Carolina-chartered bank, theBank is subject to legal limitations on the amount of dividends it is permittedto pay. Such restrictions have not had and are not expected to have an impacton the ability of the holding company to meet its cash obligations.

For a complete discussion of capitaldistribution regulations, refer to the Company's Annual Report on Form 10-K forthe year ended December 31, 2004.  

OFF BALANCE SHEET ARRANGEMENTS

In the normal course of business, the Company engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in its financial statements or are recorded in amounts that differ from the notional amounts. These transactions involve elements of credit, interest rate, and liquidity risk.

The Company's off-balance sheetarrangements principally include lending commitments and derivatives. 

Lending Commitments

TheCompany's contractual commitments to extend credit, which include home equityloan, credit card, commercial real estate development and other commitments atJune 30, 2005 totaled $202.2 million.

33

At June 30, 2005, the Companyrecorded no liability for the current carrying amount of the obligation toperform as a guarantor, and no contingent liability was considered necessary,as such amounts were not considered material. The maximum potential amount ofundiscounted future payments related to standby letters of credit at June 30,2005 was $1.9 million. Past experience indicates that many of these standbyletters of credit will expire unused. However, through its various sources ofliquidity, the Company believes that it has the necessary resources to meetthese obligations should the need arise. Additionally, the Company does notbelieve that the current fair market values of such guarantees were material atJune 30, 2005.

See Note 11 of Notes To unaudited ConsolidatedInterim Financial Statements for additional discussion of the Company's lending commitments.

Other Off-Balance Sheet ArrangementsAt June 30, 2005, the Company had nointerests in nonconsolidated special purpose entities nor is it involved in other off-balancesheet contractual relationships (other than those discussed herein),unconsolidated related entities that have off-balance sheet arrangements, ortransactions that could result in liquidity needs.

See Note 11 of Notes To unaudited ConsolidatedInterim Financial Statements for additional discussion of the Company's standby letters ofcredit.

DerivativesThe Companyhas identified the following derivative instruments at June 30, 2005:commitments to originate certain residential loans held for sale and forwardsales commitments.

The Companyoriginates certain residential loans with the intention of selling these loans.Between the time that the Company enters into an interest rate lock or acommitment to originate a fixed rate residential loan with a potential borrowerand the time the closed loan is sold, the Company is subject to variability inmarket prices. The Company believes that it is prudent to limit the variabilityof expected proceeds from the sales through forward sales of loans("forward sales commitments"). 

Outstanding commitments on mortgage loans not yet closed amounted toapproximately $8.3 million at June 30, 2005. The fair value of derivative assets related tocommitments to originate such residential loans held for sale and forward salescommitments was not significant at June 30, 2005.

See Note 12 of Notes To unaudited ConsolidatedInterim Financial Statements for additional discussion of the Company's derivatives.

EARNINGSREVIEW COMPARISONQUARTERSENDED JUNE 30, 2005 AND 2004

OverviewNet income totaled $3.5 million, or $0.55 per diluted share, for thethree month period ended June 30, 2005, compared to net income of $2.8 million,or $0.43 per diluted share, for the same period in 2004. Net income per basicshare was $0.56 for the quarter ended June 30, 2005 compared to $0.45 for thesame quarter of 2004.  

Net income for the quarter ended June 30, 2005 increased $751 thousand overthe quarter ended June 30, 2004.   Contributing to this increase over theperiods was an increase in net interest income of $1.4 million and a decreasein the provision for loan losses of $150 thousand.  Offsetting these increasesin net income were increases in noninterest expense totaling $839 thousand andincreases in the provision for income taxes totaling $482 thousand.  

34

The Company's net interest margin increased to 4.72% for the quarterended June 30, 2005 from 4.59% for the quarter ended June 30, 2004.  Averageinterest-earning assets increased by $126.4 million over these periods. 

During the second quarter of 2005, the Company's mortgage-bankingservices generated revenue growth over the second quarter of 2004 primarily dueto the loan securitizations and sales not in the ordinary course of theCompany's business transacted during the 2005 quarter that did not occur duringthe same period of 2004. Over the periods indicated, mortgage-banking incomeincreased 194.4%.  Offsetting this growth was a decline in service charges ondeposit accounts of $205 thousand.  

Noninterest expense increased by 9.6% to $9.6 million for the quarterended June 30, 2005 from $8.8 million for the quarter ended June 30, 2004 dueprimarily to an increase of $559 thousand in salaries and other personnelexpense over the periods resulting from the additional of several employeeswithin the Bank, annual salary increases, and the hiring of new employees inanticipation of the opening of the new Easley branch during the third quarterof 2005.

Income tax expense increased $482 thousand during the quarter ended June30, 2005 over the quarter ended June 30, 2004 due to an increase in projectedtaxable income relative to nontaxable adjustments.

Secondquarter 2005 earnings resulted in a return on average assets of 1.36% and areturn on average shareholders' equity of 16.86% compared with 1.30% and15.82%, respectively for the year ended December 31, 2004, and 1.23% and 15.01%at the end of the second quarter of 2004.

Net InterestIncomeThe net interest margin for thequarter ended June 30, 2005 was 4.72% compared with 4.59% during the quarterended June 30, 2004. Average interest-earning assets increased by $126.4million from the quarter ended June 30, 2004 to the quarter ended June 30, 2005to $981.5 million. Average interest-earning liabilities increased by $114.7million from the quarter ended June 30, 2004 to the quarter ended June 30, 2005to $829.2 million. The average yield on interest-earning assets increased by 55basis points while the rate paid on average interest-bearing liabilitiesincreased by 49 basis points. The yield on interest-earning assets increased to6.33% for the quarter ended June 30, 2005 from 5.78% for the quarter ended June30, 2004. The cost of interest-bearing liabilities increased to 1.91% for thequarter ended June 30, 2005 from 1.42% for the quarter ended June 30, 2004. Asa result of these variances, net interest income increased $1.8 million, or18.4%, between the two quarters.  

 

 

35

The following table summarizes theCompany's yields earned, rates paid, average interest-earning assets, andaverage interest-bearing liabilities for the periods presented (dollars inthousands). Weighted average yield on interest-earning assets and weighted averagecost of interest-bearing liabilities are derived by dividing interest incomeand expense by the weighted average balances on interest-earning assets orinterest-bearing liabilities. 

For the three month periods ended  June 30,

2005

2004

** **

Average		

Income/		

Yield/		

Average		

Income/		

Yield/		

** **

Balance

Expense

Rate

Balance

Expense

Rate

** **

ASSETS

Interest-earnings  assets

Federal  funds sold

 $          3,641		

 $         34		

       3.75		

%

 $        6,154		

 $          14		

 0.91		

%

Federal  Home Loan Bank stock and deposits

     6,129		

    59		

       3.86		

           2,622		

    20		

       3.07		

Nontaxable  investment securities (1)

 61,229		

          572		

       3.75		

         61,449		

          570		

       3.73		

Taxable  investment securities (1)

           76,864		

          733		

       3.83		

         65,164		

          443		

       2.73		

Loans, net  of unearned (2)

        833,634		

     14,099		

       6.78		

       719,678		

      11,232		

       6.28		

Total  interest-earning assets

         981,497		

     15,497		

       6.33		

      855,067		

     12,279		

       5.78		

Noninterest-earning  assets

Cash and  due from banks

   30,613		

         26,188		

Allowance  for loan losses

     (7,901)

         (7,739)

Premises  and equipment, net

   22,431		

        22,240		

Accrued  interest receivable

             4,500		

           3,729		

Other  assets

   15,569		

 15,512		

Total  noninterest-earning assets

 65,212		

        59,930		

Total  assets

 $  1,046,709		

 $   914,997		

LIABILITIES  AND SHAREHOLDERS' EQUITY

Liabilities   

Interest-bearing  liabilities

Transaction  and money market deposit accounts

 $    303,420		

 $      640		

       0.85		

%

 $  266,454		

 $      220		

       0.33		

%

Savings  deposit accounts

   49,144		

    37		

       0.30		

        47,455		

    33		

       0.28		

Time  deposit accounts

         366,175		

       2,659		

        2.91		

      345,595		

        2,134		

       2.48		

Total  interest-bearing deposits

         718,739		

       3,336		

        1.86		

      659,504		

       2,387		

    1.46		

Other  interest-bearing liabilities

    110,507		

          607		

       2.20		

        55,055		

           137		

     1.00		

Total  interest-bearing liabilities

829,246		

3,943		

  1.91		

       714,559		

       2,524		

 1.42		

Noninterest-bearing  liabilities

Noninterest-bearing  deposits

         128,269		

121,759		

Other  noninterest-bearing liabilities

             4,793		

           3,742		

Total  noninterest-bearing liabilities

         133,062		

125,501		

Total  liabilities

        962,308		

      840,060		

Shareholders'  equity

      84,401		

        74,937		

Total  liabilities and shareholders' equity

 $  1,046,709		

 $   914,997		

NET  INTEREST INCOME / NET YIELD ON

INTEREST-EARNING  ASSETS 

 $  11,554		

       4.72		

%

 $   9,755		

       4.59		

%

(1)

The  average balances for investment securities include the unrealized gain or  loss recorded for available for sale securities.

(2)

Nonaccrual  loans are included in average balances for yield computations.  The effect of  foregone interest income as a  result of loans on nonaccrual was not considered in the above analysis.  All  loans and deposits are domestic.

 

 

36

 

The following rate / volume analysisdepicts the increase (decrease) in net interest income attributable to interestrate and volume fluctuations when comparing the three month period ended June30, 2005 to the three month period ended June 30, 2004 (in thousands). 

For the quarter ended June 30, 2005  compared with the quarter ended June 30, 2004
		 
Volume

Rate

Total

Interest-earnings  assets
 
Loans, net  of unearned 
$
    1,876 

            991 

      2,867 

Investment  securities 
		 
            97 

         195 

        292 

Other
		 
           4 

        55 

          59 

Total  interest-earning assets
$
1,977 

          1,241 

         3,218 
 
Interest-bearing  liabilities
 
Total  interest-bearing deposits
$
           229 

      720 

        949 

Other  interest-bearing liabilities
		 
       		214 

          256 

           470 

Total  interest-bearing liabilities
$
         443 

          976 

    1,419 
 
NET  INTEREST INCOME 
$
     1,534 

      265 

        1,799 
 
One main reason for changes in therates earned on interest-earning assets and rates paid on interest-bearingliabilities has been increases in the federal funds rate by the Federal ReserveOpen Market Committee.

Provisionfor Loan LossesThe provision for loan losses is acharge to earnings in a given period in order to maintain the Allowance at anadequate level defined by the Company's Allowance model. The provision for loanlosses is adjusted each month to reflect loan growth and to allow for loanscharged-offs, recoveries, and other factors that impact Management's assessmentof the adequacy of the Allowance. Management's objective is to maintain theAllowance at an adequate level to cover probable losses in the portfolio.Additions to the Allowance are based on Management's evaluation of the loanportfolio under current economic conditions, past loan loss experience, andsuch other factors that, in Management's judgment, deserve consideration inestimating loan losses. Theprovision for loan losses was $600 thousand and $750 thousand for the threemonth periods ended  June 30, 2005 and 2004, respectively.  The Allowanceat June 30, 2005,December 31, 2004, and June 30, 2004 was $8.1 million, $7.6 million, and$8.0 million, respectively and represented 0.97%, 0.99%, and 1.11% of loans excluding mortgage loans heldfor sale, net of unearned and excluding the Allowance for the same dates,respectively.  

The provision for loan losses declinedfrom the three month period ended June 30, 2004 to the same period of 2005primarily as a result of decreased net loans charged- off and nonperformingloans, and relatively unchanged classified assets over the same periods. Netloans charged-off during the three month period ended June 30, 2005 totaled$387 thousand, down from $459 thousand during the three month period ended June30, 2004. Nonperforming assets declined from $3.0 million at June 30, 2004 to$2.3 million at June 30, 2005. Additionally, classified assets declined from$17.5 million at June 30, 2004 to $17.3 million at June 30, 2005. These factorswere offset slightly by the impact of the growth of the loan portfolio over theperiods.

See Financial Condition-Loan Portfolioand Allowance for Loan Losses, and Note 4 of Notes to Consolidated InterimFinancial Statements contained herein for additional discussion includingfactors impacting the Allowance and thus the provision for loan losses as wellas the methodology for analyzing the adequacy of the Allowance.

37

NoninterestIncomeNoninterest income for the three month period ended June 30,2005 totaled $4.0 million, up $123 thousand compared with the second quarter of2004. The main contributors to the increase in noninterest income was anincrease in mortgage-banking income of $313 thousand offset by a decrease inservice charges on deposit accounts.  

Service charges on deposit accounts comprise a significant component of other noninterest income and comprised 50.1% of noninterest income during the second quarter of 2005 compared with 57.0% of noninterest income during the second quarter of 2004. Service charges on deposit accounts decreased $205 thousand, or 9.3%, during the quarter ended June 30, 2005 when compared with the same quarter of 2004. Management believes that the decline in service charges on deposit accounts is primarily related to nonsufficient funds and overdraft service charge declines due to customers' increased use of the Company's overdraft protection program as well as an increase in alternative transaction methods such as debit cards.  This increased use of debit cards has decreased the Company's service charge opportunities, since transactions that would otherwise result in overdrafts are typically declined by the merchant.

Mortgage-banking income increased $313 thousand during thequarter ended June 30, 2005 when compared with the same quarter of 2004.  Theincrease in mortgage-banking income was principally related to higher gains onsales of loans that were attributed to increased originations and sales ofloans over the periods noted as well as a loan securitization during the secondquarter of 2005.  Residential mortgage loans originations during this periodwere offset by prepayments as well as a loan securitization and loan salesduring the second quarter of 2005 totaling approximately $14 million.  Duringthe second quarter of 2005, the Company securitized and sold approximately $10million of its 1-4 family mortgage loans. The goal of this securitization wasto provide enhanced liquidity resources, improve capital ratios, and to providegrowth in revenues from off-balance sheet servicing activities. In addition tothis securitization, approximately $4 million residential mortgage loans weresold during the second quarter of 2005 from the loans receivable portfolio. Activity impacting the Company's mortgage-banking activities is reflected inthe Consolidated Statement of Cash Flows contained herein.

After excluding the fluctuations in noninterest incomerelative to service charges on deposit accounts and mortgage banking income,all other sources of other noninterest income increased by $15 thousand duringthe current quarter over the prior year quarter. 

NoninterestExpenseIn the more competitive financialservices market of recent years, Management has recognized the importance ofcontrolling noninterest expense to maintain and improve profitability.Management also recognizes that there are operational costs that continue toincrease as a result of the present operating climate for regulated financialinstitutions. The technical and operating environment for financialinstitutions continues to require a well-trained and motivated staff, superioroperating systems, and sophisticated marketing efforts.

Noninterest expense for the quarterended June 30, 2005 increased $839 thousand, or 9.6%, to $9.6 million from $8.8million in the quarter ended June 30, 2004. Contributing to the increase innoninterest expense for the quarter ended June 30, 2005 over the quarter endedJune 30, 2004 was an increase in salaries and other personnel expense and othernoninterest expense.  

Salaries and other personnel expensecomprise a significant component of noninterest expense. Comprising 58.5% ofnoninterest expense in the second quarter of 2005 and 57.7% of noninterestexpense in the second quarter of 2004, salaries and other personnel expenseincreased by $559 thousand to $5.6 million in the second quarter of 2005 from$5.0 million in the second quarter of 2004. The majority of the increase wasdue to normal increases in employee and officer salaries as well as increasesin expenses associated with the Company's Officer Incentive Compensation Planand the addition of new officer positions including those positions created inanticipation of the opening of the new Easley branch during the third quarterof 2005. Additionallyexpenses related to the Company's defined benefit pension plan increased duringthe second quarter of 2005 over the same period of 2004 as a result of theCompany's focus on its pension obligations and related asset returns.  

38

Othernoninterest expense increased $234 thousand during the second quarter of 2005to $1.4 million over the second quarter of 2004. This increase was the resultof changes in several accounts, none of which constitute material fluctuations.

IncomeTaxesIncome tax expense totaled $1.8million for the quarter ended June 30, 2005, compared with $1.3 million for thequarter ended June 30, 2004. The Company's effective tax rate was 33.5% and31.8% for the three month periods ended June 30, 2005 and 2004, respectively. 

EARNINGSREVIEW COMPARISONSIX MONTHPERIODS ENDED JUNE 30, 2005 AND 2004

OverviewNet income totaled $7.0 million, or $1.08 per diluted share, for the sixmonth period ended June 30, 2005, compared to net income of $5.8 million, or$0.91 per diluted share, for the same period in 2004. Net income per basicshare was $1.10 for the six month period ended June 30, 2005 compared to $0.93for the same period of 2004.  

Net income for the six month period ended June 30, 2005 increased $1.1million over the six month period ended June 30, 2004.   Contributing to thisincrease over the periods was an increase in net interest income of $2.9million and a decrease in the provision for loan losses of $300 thousand. Offsetting these increases in net income were increases in noninterest expensetotaling $1.4 million and the provision for income taxes totaling $764thousand.  

The Company's net interest margin increased to 4.69% for the six monthperiod ended June 30, 2005 from 4.66% for the six month period ended June 30,2004.  Average interest-earning assets increased by $120.0 million over theseperiods.  

During the first six months of 2005, the Company's mortgage-bankingservices generated revenue growth over the first six months of 2004 primarilydue to the loan securitizations and sales not in the ordinary course of theCompany's business transacted during the first six months of 2005 that did notoccur during the same period of 2004. Over the periods indicated,mortgage-banking income increased $430 thousand.  Offsetting this growth was adecline in service charges on deposit accounts of $441 thousand.  

During the second quarter of 2005, the Company's mortgage-bankingservices generated revenue growth over the second quarter of 2004 primarily dueto the loan securitizations and sales not in the ordinary course of the Company'sbusiness during the 2005 quarter that did not occur during the same period of2004.

Noninterest expense increased by 8.2% to $18.4 million for the six monthperiod ended June 30, 2005 from $17.0 million for the six month period endedJune 30, 2004 due primarily to an increase of $887 thousand in salaries andother personnel expense over the periods resulting from the additional ofseveral employees within the Bank, annual salary increases, and the hiring ofnew employees in anticipation of the opening of the new Easley branch duringthird quarter 2005.

Income tax expense increased $764 thousand during the six month periodended June 30, 2005 over the six month period ended June 30, 2004 due to anincrease in projected taxable income relative to nontaxable adjustments.

Six monthperiod ending June 30, 2005 earnings resulted in a return on average assets of1.37% and a return on average shareholders' equity of 16.80% compared with1.30% and 15.82%, respectively for the year ended December 31, 2004, and 1.30%and 15.74% at the end of the second quarter of 2004.

NetInterest Income

The net interest margin for the six month period ended June 30, 2005 was 4.69% compared with 4.66% during the six month period ended June 30, 2004. Average interest-earning assets increased by $120.0 million from the six month period ended June 30, 2004 to the quarter ended June 30, 2005 to $961.1 million. Average interest-earning liabilities increased by $104.8 million from the six month period ended June 30, 2004 to the six month period ended June 30, 2005 to $811.1 million. The average yield on interest-earning assets increased by 38 basis points while the rate paid on average interest-bearing liabilities increased by 40 basis points. The yield on interest-earning assets increased to 6.25% for the six month period ended June 30, 2005 from 5.87% for the six month period ended June 30, 2004. The cost of interest-bearing liabilities increased to 1.84% for the six month period ended June 30, 2005 from 1.44% for the six month period ended June 30, 2004. As a result of these variances, net interest income increased $2.9 million, or 14.7%, between the two periods. 

39

The following table summarizes theCompany's yields earned, rates paid, average interest-earning assets, andaverage interest-bearing liabilities for the periods presented (dollars inthousands). Weighted average yield on interest-earning assets and weightedaverage cost of interest-bearing liabilities are derived by dividing interestincome and expense by the weighted average balances on interest-earning assetsor interest-bearing liabilities.

For the six month periods ended  June 30,

2005

2004

** **

Average		

Income/		

Yield/		

Average		

Income/		

Yield/		

** **

Balance

Expense

Rate

Balance

Expense

Rate

** **

ASSETS

Interest-earnings  assets

Federal  funds sold

 $        3,644		

 $          55		

       3.04		

%

 $       5,996		

 $         29		

       0.97		

%

Federal  Home Loan Bank stock and deposits

            5,356		

    102		

       3.84		

       2,614		

   39		

       3.00		

Nontaxable  investment securities (1)

          63,939		

 1,190		

       3.75		

         58,103		

        1,080		

       3.74		

Taxable  investment securities (1)

          76,036		

         1,449		

       3.84		

        62,852		

           889		

       2.84		

Loans, net  of unearned (2)

         812,163		

      26,990		

       6.70		

  711,607		

     22,503		

       6.36		

Total  interest-earning assets

         961,138		

      29,786		

       6.25		

       841,172		

     24,540		

       5.87		

Noninterest-earning  assets

Cash and  due from banks

    31,128		

         26,851		

Allowance  for loan losses

          (7,775)

  (7,616)

Premises  and equipment, net

          22,353		

        22,058		

Accrued  interest receivable

    4,411		

           3,778		

Other  assets

           15,460		

         15,296		

Total  noninterest-earning assets

          65,577		

        60,367		

Total  assets

 $  1,026,715		

 $   901,539		

LIABILITIES  AND SHAREHOLDERS' EQUITY

Liabilities   

Interest-bearing  liabilities

Transaction  and money market deposit accounts

 $    294,081		

 $      1,071		

       0.73		

%

 $  264,990		

 $       445		

       0.34		

%

Savings  deposit accounts

          47,520		

    69		

       0.29		

         45,831		

             64		

       0.28		

Time  deposit accounts

       369,070		

         5,197		

       2.84		

      347,794		

       4,335		

    2.51		

Total  interest-bearing deposits

         710,671		

 6,337		

 1.80		

       658,615		

       4,844		

 1.48		

Other  interest-bearing liabilities

        100,380		

         1,082		

   2.17		

        47,597		

           202		

       0.85		

Total  interest-bearing liabilities

 811,051		

         7,419		

1.84		

       706,212		

       5,046		

   1.44		

Noninterest-bearing  liabilities

Noninterest-bearing  deposits

        127,457		

       117,257		

Other  noninterest-bearing liabilities

            4,705		

           3,633		

Total  noninterest-bearing liabilities

         132,162		

       120,890		

Total  liabilities

        943,213		

       827,102		

Shareholders'  equity

          83,502		

        74,437		

Total  liabilities and shareholders' equity

 $  1,026,715		

 $   901,539		

NET  INTEREST INCOME / NET YIELD ON

INTEREST-EARNING  ASSETS 

 $  22,367		

       4.69		

%

 $  19,494		

       4.66		

%

(1)

The  average balances for investment securities include the unrealized gain or  loss recorded for available for sale securities.

(2)

Nonaccrual  loans are included in average balances for yield computations.  The effect of  foregone interest income

as a  result of loans on nonaccrual was not considered in the above analysis.  All  loans and deposits are domestic.

40

The following rate / volume analysisdepicts the increase (decrease) in net interest income attributable to interestrate and volume fluctuations when comparing the six month period ended June 30,2005 to the six month period ended June 30, 2004 (in thousands).  

For the six month period ended June  30, 2005 compared with the six month period ended June 30, 2004
		 
Volume

Rate

Total

Interest-earnings  assets
 
Loans, net  of unearned 
$
              3,299 

  1,188 

   4,487 

Investment  securities 
		 
      334 

  336 

    670 

Other
		 
      3  		

     86 

  89 

Total  interest-earning assets
$
              3,636 

   1,610 

         5,246 
   
Interest-bearing  liabilities
 
Total  interest-bearing deposits
$
      405 

   1,088 

     1,493 

Other  interest-bearing liabilities
		 
      368 

          512 

     880 

Total  interest-bearing liabilities
$
    773 

     1,600 

         2,373 
   
NET  INTEREST INCOME 
$
         2,863 

10  		

      2,873 
 
One main reason for changes in therates earned on interest-earning assets and rates paid on interest-bearingliabilities has been increases in the federal funds rate by the Federal ReserveOpen Market Committee.

Provisionfor Loan LossesThe provision for loan losses was $1.2 million and $1.5million for the six month periods ended June 30, 2005 and 2004, respectively. 

The provision for loan losses declinedfrom the six month period ended June 30, 2004 to the same period of 2005primarily as a result of decreased net loans charged- off and nonperformingloans when comparing the six month period ended June 30, 2005 with the sixmonth period ended June 30, 2004, and relatively unchanged classified assetsover the same periods. Net loans charged-off during the six month period endedJune 30, 2005 totaled $768 thousand, down from $980 thousand during the sixmonth period ended June 30, 2004. Nonperforming assets declined from $3.0 millionat June 30, 2004 to $2.3 million at June 30, 2005. Additionally, classifiedassets declined from $17.5 million at June 30, 2004 to $17.3 million at June30, 2005. These factors were offset slightly by the impact of the growth of theloan portfolio over the periods.

See Financial Condition-Loan Portfolioand Allowance for Loan Losses, and Note 4 of Notes to Consolidated InterimFinancial Statements contained herein for additional discussion includingfactors impacting the Allowance and thus the provision for loan losses as wellas the methodology for analyzing the adequacy of the Allowance.

NoninterestIncomeNoninterest income for the six month period ended June 30,2005 totaled $7.7 million, up $115 thousand compared with the six month periodended June 30,2004. The main contributors to the increase in noninterest incomewas an increase in mortgage-banking income of $430 thousand offset by adecrease in service charges on deposit accounts. 

Service charges on deposit accounts comprise a significant component of other noninterest income and comprised 50.0% of noninterest income during the six month period ended June 30, 2005 compared with 56.5% of noninterest income during the six month period ended June 30, 2004. Service charges on deposit accounts decreased $441 thousand, or 10.3%, during the six month period ended June 30, 2005 when compared with the same period of 2004 due to same factors discussed in Earnings Review Comparison Quarters Ended June 30, 2005 and 2004 - Noninterest Income.

Mortgage-banking income increased $430 thousand during the six month period ended June 30, 2005 when compared with the same period of 2004.  The increase in mortgage-banking income was due to same factors discussed in Earnings Review Comparison Quarters Ended June 30, 2005 and 2004 - Noninterest Income. 

After excluding the fluctuations in noninterest incomerelative to service charges on deposit accounts and mortgage banking income,all other sources of other noninterest income increased by $126 thousand duringthe six month period ended June 30, 2005 over the same period of 2004. 

NoninterestExpenseNoninterest expense for the six monthperiod ended June 30, 2005 increased $1.4 million, or 8.2%, to $18.4 millionfrom $17.0 million in the six month period ended June 30, 2004. Contributing tothe increase in noninterest expense for the six month period ended June 30,2005 over the six month period ended June 30, 2004 was an increase in salariesand other personnel expense and other noninterest expense.  

Salaries and other personnel expense comprise a significant component of noninterest expense. Comprising 57.5% of noninterest expense in the six month period ended June 30, 2005 and 57.0% of noninterest expense in the six month period ended June 30, 2004, salaries and other personnel expense increased by $887 thousand to $10.6 million in the first six months of 2005 from $9.7 million in the first six months of 2004. The majority of the increase was due to normal increases in employee and officer salaries as well as increases in expenses associated with the Company's Officer Incentive Compensation Plan and the addition of new officer positions including those positions created in anticipation of the opening of the new Easley branch during the third quarter of 2005. Additionally expenses related to the Company's defined benefit pension plan increased during the second quarter of 2005. Additionally expenses related to the Company's defined benefit pension plan increased during the first six months of 2005 over the same period of 2004 as a result of the Company's focus on its pension obligations and related asset returns. 

41

Othernoninterest expense increased $408 thousand during the first six months of 2005to $2.8 million over the first six months of 2004. This increase was the resultof changes in several accounts, none of which constitute material fluctuations.

IncomeTaxesIncome tax expense totaled $3.5million for the six month period ended June 30, 2005, compared with $2.7million for the same period of 2004. The Company's effective tax rate was 33.5%and 32.0% for the six month periods ended June 30, 2005 and 2004,respectively. 

ACCOUNTING AND REPORTING MATTERS

See Note 1of Item 1, Financial Statements for a discussion regarding accountingpronouncements recently adopted by the Company.

Otheraccounting standards that have been issued or proposed by the FASB or otherstandards-setting bodies that do not require adoption until a future date arenot expected to have a material impact on the consolidated financial statementsupon adoption.

**Item 3. Quantitative and Qualitative Disclosures about Market Risk**

See Item 2.Management's Discussionand Analysis of Financial Condition and Results of Operations - DisclosuresRegarding Market Risk for quantitative and qualitative disclosures about market risk.

**Item 4. Controls and Procedures**

Evaluation of Disclosure Controls andProceduresAn evaluation of the Company'sdisclosure controls and procedures (as defined in Rule 13a-15(e) and Rule15d-15(e) under the Securities Exchange Act of 1934) was carried out under thesupervision and with the participation of the Company's Chairman and ChiefExecutive Officer and the Company's President and Chief Operating Officer(Chief Accounting Officer) as of the end of the period covered by thisQuarterly Report (the "Evaluation Date"). The Company's Chairman and ChiefExecutive Officer and the Company's President and Chief Operating Officer(Chief Accounting Officer) concluded as of the Evaluation Date that disclosurecontrols and procedures were effective in providing reasonable assurance thatthe information required to be disclosed by the Company in the reports it filesor submits under the Securities Exchange Act of 1934 is (i) accumulated andcommunicated to Management (including the Company's Chairman and ChiefExecutive Officer and the Company's President and Chief Operating Officer(Chief Accounting Officer)) in a timely manner, and (ii) recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission's rules and forms.

Changes in Internal ControlsDuring the second quarter of 2005, the Company did not make any change inits internal control over financial reporting or other factors that hasmaterially affected, or is reasonably likely to materially affect, its internalcontrol over financial reporting. 

 

42

**PART II.  OTHER INFORMATION**

**Item 1. Legal Proceedings**

See Note 11of the Notes ToConsolidated Interim Financial Statements for a discussion of legal proceedings.

**Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds**

None

**Item 3.  Defaults Upon Senior Securities**

None

**Item 4.  Submission of Matters to a Vote of Securities Holders**

TheCompany's Annual Shareholders' Meeting was held on April 19, 2005, and therewere 5,175,663 shares present in person or by proxy of the 6,313,185 shares ofcommon stock entitled to vote at the Annual Shareholders' Meeting.  

Proposal #1- Election of Directors.  At the meeting the following directors were electedfor three year terms ending in 2008:

Number of  VotesFor

Number of  VotesWithheld

John T.  Gramling, II

5,173,762

1,901

John D.  Hopkins, Jr.

5,172,147

3,516

Edward K.  Snead, III

4,953,472

222,191    

Paul W.  Stringer

5,167,214

8,449

The following director's term of office continued after themeeting: W. Fred Davis, Jr., David P. George, Jr., Michael D. Glenn, L. LeonPatterson, Sam B. Phillips, Jr., Ann B. Smith, and J. David Wasson, Jr.

On March 26, 2005, Director WilliamS. Moore passed away after a short illness. Mr. Moore's vacancy will be filledin accordance with the Company's Bylaws and Articles of Incorporation.

**Item 5. Other Information**

None

**Item 6. Exhibits**

31.1      L. Leon Patterson'sCertification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 

31.2      Paul W. Stringer'sCertification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 

32         CertificationsPursuant to Section 906 of the Sarbanes-Oxley Act of 2002 

 

 

43

 

 

**SIGNATURES**

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

PALMETTO BANCSHARES, INC.

/s/      L. LeonPatterson                            L. Leon Patterson Chairman and Chief ExecutiveOfficer

/s/      Paul W. Stringer                                Paul W. Stringer President and Chief OperatingOfficer (Chief Accounting Officer)

 

Dated:   August 9, 2005

 

 

 

 

 

 

44
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